rbi balancing act between growth and inflation
TRANSCRIPT
PROJECT REPORT ON RBI’S BALANCING ACT BETWEEN GROWTH AND INFLATION
SUBMITTED TO:
NISHA THOMAS
SUBMITED BY:
PRADEEP KUMAR SAHOO
PGP NUMBER:PGP20095214
MOBILE NUMBER:+91-9776545106
IILM INSTITUTE OF HIGHER EDUCATION, GURGAON
Inflation- RBI's balancing act between growthand inflation
The relationship between growth and inflation has changed. Growth is more broad-based and inflation, too, has become more broad-based. Demand pressures will add to inflation. But the same demand pressures also incentivize growth. When does this incentive become de-stabilizing? It has been a big challenge in calibrating the policy in the context of growth/inflation parameters. We are deeply sensitive to the fact that as you raise rates lending rates too go up, which means that even to productive sectors lending might fall. So you have to calibrate policy in such a way that you are not just signaling demand management to anchor inflation expectations. But investment has picked up, even as you tighten. Potential investors look at not just today's interest rates, they look at interest rates over several cycles. So it is not just as if they do not know that interest rates are going to go up, because everybody is talking about it. We have said ourselves that our current interest rates are not consistent with the pace of our economy. So, they all know we are going to raise them. In spite of that they are taking a long-term position. Our hope is that even as we raise rates in order to bring them to neutral levels, which is important and necessary to combat inflation we do not hurt the investment sentiment.
There has been a substantial jump in market borrowings (36 per cent). What is the challenge — is it private investment being crowded out or is a challenge for RBI to calibrate interest rates, yields? The latter; RBI must make sure that there is enough liquidity to meet demands of government and private sector. At the same time RBI must make sure that there is not too much liquidity to fuel inflation. How much liquidity do we suck out? And how do we do it in such a way that there is no flip flop? I can't raise CRR today and lower it tomorrow. It is possible that we tighten liquidity and inflation is controlled but costs of borrowing go up. We don't want that to happen. It is to balance all these considerations that we maintain interest rates reasonably and ensure that policy is consistently moving in one direction.
What does RBI prefer for the expansion of foreign banks – the subsidiary or branch route?
RBI does not have a preference for either at the moment. We will await the proposed discussion paper. I want to clarify that this (policy) is not a full fledged review of the entry of foreign banks into India which was due in 2009 and which we have deferred. Pending a full review we thought that this is an issue that we must recognize because of the cross border regulations and the need to standardize one model. I would have thought that the subsidiary route was better, because it would be easier to ring fence the capital in case of a crisis. But
when I meet other governors of other emerging market economies, they say that the costs and benefits of both are the same. But we will await the discussion paper before we formulate our own view.
What are the implications of allowing banks to accept receivables by way of annuity payments and toll in a BOT project as security in case of lending for infrastructure projects? What does ‘legally enforceable' mean? Receivables by way of annuity payments and receivables by way of toll — if they are irrevocable and the right to receive them is legally enforceable — will now be treated as security. It means that in the contract between the private party and the government authority building the infrastructure the right of the person doing the BOT to get the annuity and collect the toll is legally enforceable. It is quite possible that his right to receive that it is not so; if the contract is revoked and there is no legal recourse, there is a threat to the security. The belief that this is going to open up infrastructure lending is illusory. There are lots of things we need to do. This is just one more small measure.
RBI continues its balancing act
In recent months the Reserve Bank of India has had to walk a tightrope, and ensure that it strikes the right balance between maintaining the growth momentum of the Indian economy and managing inflation. As inflation became an immediate and pressing concern, in the six months leading up to today's Annual Policy Statement (Policy), RBI announced a series of measures aimed at containing inflation. These included increasing CRR (cash reserve ratio) balances and repo rates, and raising provisioning requirements and risk weights on banks exposure to certain sensitive sectors. Today's Policy seems to indicate that RBI will wait to see how these measures succeed; key interest rates have therefore been left unchanged. RBI has articulated that it is targeting an inflation rate of 5% in 2007-08. This means that if inflation does not show some quick signs of abatement, we can expect further rate increases. Over last twelve months, we have seen that major rate changes do not necessarily happen at the time of the annual and mid-term policy announcements. RBI's agenda is further complicated by the strong foreign exchange inflows into India, which expand liquidity and negate the effect of monetary policy measures such as increases in CRR and repo rates. The policy focus, therefore, is to liberalize the outflow of foreign exchange while making foreign currency inflows less attractive.
RBI also seems to have heeded the concerns that have been voiced across the board about choking funding to deserving sectors, and has made lending to smaller ticket housing loans easier, by reducing the risk weights on housing loans below Rs 2 million. In this environment, RBI's effort to strike the right balance between growth and inflation will necessarily be a dynamic one, and over the rest of the year we can expect to see further calibrations in key parameters like interest rates, risk weights and level of support to the rupee. Are the monetary contraction measures succeeding? Although inflation continues to be at about 6.1%, credit growth has clearly slowed down. Credit growth in banks declined to 28% in
2006-07, from 31% in the year 2005-06. Typically, it takes about a year for the impact of the monetary policy changes to fully manifest them; further moderation can therefore also be expected. However, since the main reason for high inflation is the significant increase in the prices of food articles, and supply side constraints in commodity sectors like cement, oil and steel, it is important to note that the monetary policy tightening alone may not be able to help in containing inflation. The measures to liberalize the outflow of foreign exchange include increasing the limits on foreign investments by Indian companies, allowing higher limits of overseas investments by mutual funds and enhancing the limits for prepayment of External Commercial Borrowings without prior RBI approval. These moves further the agenda of increased capital account convertibility. RBI has also undertaken steps to make foreign currency inflows less attractive; by reducing the cap on interest rates payable on Foreign Currency Non Resident and Non Resident External deposits The policy also includes longer term initiatives which will strengthen financial markets through product innovation. Committees have been formed to look at widening of the repo market to include corporate bonds, currency futures, and interest rate futures. A quick launch of these products and tools will increase the sophistication and depth of our markets. The introduction of the credit derivatives in a calibrated manner has begun, and is a welcome move. In its mid-quarterly monetary policy review announced on Thursday (17th March), the Reserve Bank of India (RBI), on the basis of its assessment of the current macroeconomic environment made the following announcement:
· increase the repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 6.5 per cent to 6.75 per cent with immediate effect; and
· increase the reverse repo rate under the LAF by 25 basis points from 5.5 per cent to 5.75 per cent with immediate effect
It has, however, kept the CRR unchanged at 6%.
To me, an interesting part of the statement is their acceptance that the inflation for the current financial year (Apr’10-Mar’11) will be higher than they previously anticipated. It would be useful to remember that in my article dated 26th January (RBI falling behind the inflation curve), I insisted that RBI has been under-estimating the inflation numbers for India. In the recent review, their estimate of inflation for end March’11 has been increased from 7% to 8%. Rarely has one seen inflation estimate for a particular period going up by as much as 100 basis points within less than two months. And, that too by a central bank.
To a certain extent, I sympathies with the RBI. In the same statement, RBI talked about fears of inflation emanating from narrowing output gap. I have been maintaining that India is a supply constrained economy and any Endeavour to jack up growth rates would lead to building up of inflationary pressure. In essence, what is required is to continue with structural reforms, invest more in agriculture and other physical infrastructures, remove roadblocks and reduce leakages that put pressure on deficits. Unfortunately, while the solutions are known, not much headway is made in these regard leaving RBI to use monetary policy as the only instrument to fight
inflation. Problem is, squeezing credit availability or raising interest comes at the cost of growth, leaving RBI to try and bring about a fine balance between growth and inflation. This becomes more problematic in a situation when there’s enough and more uncertainty about global growth prospects.
2011 will be a weak year for Europe reeling under large scale austerity measures across nations. In addition, with inflation rising, ECB may opt for higher rates, further impacting the growth. In case of the US, although inflation is yet to reach concerning levels, there is a clear threat for a rise through the import channel. Their Import Price Index has been rising, as has been the Producer Price Index (PPI). There is now a glaring difference between the US PPI and the CPI. The NFIB Small Business Optimism Index showed that the percentages of respondents raising average selling prices continued to gain ground in January. In addition, January’s Morgan Stanley Business Conditions Index yielded a new 31-month high in the number of survey participants whose firms had charged higher prices relative to a year ago. Remember, US debt/GDP ratio is to touch 1005 this year. With the country building up on debts when the interest rates were at its lowest, It is only a matter of time that the situation will deteriorate as the interest rates bottom out and start moving up. The RBI already has a medium-term inflation objective of 5 percent that irregularly cited in speeches by its leading officials. But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interstate, at its disposal; it performs a high-wire balancing act, with the objective of monetary policy depending on the particular economic circumstances. What is wrong with this? Simple that by trying to do too many things at once, the RBIrisks doing none of them well. For instance, it is now widely recognized that a central bank needs to control the public’s expectations of inflation in order to manage actual inflation. If workers think prices are not going to increase rapidly, they are less likely to demand a compensating increase in their wages, thus preventing an inflationary spiral from taking off. But if the public never knows whether the central bank is going to focus on the nominal exchange rate or the inflation rate, it is confused. It is likely to have higher inflationary expectations, and be more sensitive to any local price jump, which even if from imported goods like oil, could initiate an inflationary spiral. This confusion is compounded when foreign capital flows into the country in copious amounts, as is now the case, since this pushes the exchange rate to appreciate. While the central bank can intervene in currency markets, buy the inflows of foreign currency by exchanging it for domestic currency, and re-export the foreign currency (meanwhile withdrawing the domestic currency it has printed by issuing “market stabilization “bonds), there are limits to this process. Eventually, the central bank has to decide whether to allow the nominal exchange rate to appreciate or allow higher inflation. A central bank with multiple objectives will flit between the two, implying further confusion and possibly adding to inflationary expectations.
The RBI has managed the balancing act as best as it possibly can so far. But the rope is fraying under its feet. Could we make its job easier? Our suggestion is to move towards a single objective for monetary policy—low and stable inflation. But this is not about sacrificing growth or other important objectives at the altar of low inflation. There is no long-run tradeoff
between growth and inflation, and for monetary policy to try and engineer a short-run tradeoff can be dangerous. Wellanchoredinflation expectations constitute the best tonic that monetary policy can provide for growth. The evidence also shows that low and stable inflation reduces macroeconomic volatility and is good for financial stability. Even exchange is lower in inflation targeting economies. While there are shocks that will buffet the exchange rate, stable macroeconomic policies at least prevent those policies from themselves becoming a source of uncertainty. If we intervene haphazardly, the exchange rate will move in bigger jumps, and we will also create bigger one-way bets. Moreover, focusing on an inflation objective can be useful in communicating that monetary policy has its limits. It can be a recipe for disaster if the public believes that monetary policy is a panacea for all the ills that an economy faces, and expects the RBI to produce magic somehow. Would a central bank with an inflation objective simply continue pushing inflation down even when the economy is self-destructing on high interest rates? Of course not! If inflation is expected to be below the objective, as would be true if the economy slows, thereby would cut rates, just as it would raise rates if inflation was expected to be above objective. The U.S. Federal Reserve is cutting interest rates because it believes the current recession will bring inflation down significantly below its target. Indeed, the RBI’s objective could be restated as low inflation, and growth consistent with the economy’s potential. They amount to essentially the same thing! But it would let thereby off the hook for targeting the exchange rate. And that is the key point. Shouldn’t monetary policy have some more freedom to compensate for other huge problems in the economy—an inflexible labor market, inadequate infrastructure and, most important, fiscal policy whose discipline is open to question. The report highlights the need for fiscal policy those results in a reduction of the government budget deficit and the level of public debt. And the other problems could constrain the effectiveness of monetary policy and, more directly, India’s long-term growth. But all of this only puts even greater demands on monetary policy. Adding another constraint—in the form of an exchange rate target—is hardly the right solution. Finally, what about the argument that a focus on inflation is a rich country luxury? Time and again, our politicians refute this—and rightly so--by emphasizing the control of inflation as being essential for the poor. Indeed, we are at a better starting place than most countries in that we have a consensus that low inflation is necessary. And if emerging markets around the world can develop the tools to measure inflation and inflationary expectations, as well as models to track them, why can’t we?
The Reserve Bank of India today raised key short-term interest rates by 25 basis points — or a quarter of a percentage point — in an attempt to tame inflation which has been running at 8.4 per cent while being careful not to scupper economic growth. It, however, sharply raised the inflation forecast for the year ended March 31 to 7 per cent from 5.5 per cent earlier. As widely expected, the central bank raised both the repo and the reverse repo rates by 25 basis points each to 6.5 per cent and 5.5 per cent, respectively. The repo is the rate at which the RBI provides liquidity to banks and reverses repo is that at which it absorbs money from banks. Despite the increase in these two key rates, those paying equated
monthly installments for their home loans need not worry as senior bankers indicated that there would not be any immediate increase in lending rates. They, however, maintained that there was an upward bias in interest rates, hinting that both deposit and lending rate hikes could happen in the future.“The 25 basis points increase in policy rates will not immediately translate into deposit rate and lending rate increase,” said Chandra Kocher, managing director and chief executive officer of ICICI Bank. Admitting that the central bank had flirted with the idea of raising rates by 50 basis points, RBI governor Duvvuri Subarea told reporters that it was in the end a “judgment call” to go in for the moderate rate hike.
He explained that while the RBI had increased rates seven times since March last year, there was some more monetary transmission that had still to be played out. Further, monetary policy is not that effective when it comes to inflation driven by supply-side factors as is evident at present. The monetary policy review also saw the RBI sharply raising the inflation forecast for March. It was quick to add that though the current spike in food prices is expected to be transitory, prospect of food inflation spilling over to general inflation prices is becoming a reality. The RBI’s comments on inflation and upping of the forecast unnerved the stock markets as fears of more hikes in the coming months led to the BSE sensex falling nearly 182 points to 18969.45. On the other hand, the RBI retained its projection of 8.5 per cent growth in real GDP, but with an upside bias. The RBI also came out with guidance beyond the current fiscal. It said the coming year would see domestic growth momentum stabilizing though the GDP growth might decline as agriculture reverted to its trend. Inflation, it said, could also moderate from the first quarter of 2011-12.
The Finance Minister in the previous month had indicated various measures through the union budget to sustain the growth momentum of the country and contain inflation at sustainable levels. In order to address these issues, the Reserve Bank of India (RBI) seems to be undertaking a balancing act between growth and inflation. The RBI increased the repo and reverse repo rate by 25 basis points (bps) each earlier this month making this the 8th such increase since February 2010. Currently the repo and reverse repo rate stands at 6.75% and 5.75%respectively.The rate of inflation finally seems to be cooling off with the monthly Whole Price Index remaining in the range of 8.2% to 8.3%in the previous two months. This insignificantly lower than the double digit inflation rate recorded in the previous year. However, the consistent rise in the price ofFood articles and fuel over the last few months has resulted in the RBI revising its targeted rate of inflation to 8% for March 2011from the earlier 5.5%. It seems that RBI has accepted the fact that inflation in the Indian economy will remain on the higher side in the medium term.The RBI increased2010 5.5%End of January 2011 7.0%Early March 2011 8.0%
Targeted Wholesale Price Index (WPI) by RBI
The continuous hike in policy rates by the RBI may have brought inflation under control.
However, it appears to have negatively impacted the industrial growth of the country with the Index of Industrial Production (IIP) remaining below 5% for three consecutive months. Although high base effect of the previous year could be one of the primary reasons for such an abysmal performance of IIP in the last few months, the rigidness of the index to remain below 5% for three consecutive months is an area of concern. If the index continues to perform poorly in the coming months too, it could pose a serious threat to the growth story of the nation.In the last few years, India has been one of the largest recipients of Foreign Direct Investments (FDI) among the emerging economies. However, over the last two years, the pace of FDI inflows into the country seems to have slowed down considerably. In 2010-11, the FDI inflow witnessed a drop of more than 25% to US$ 17.1 bn in the first10 months compared to the similar period ofPrevious year where the inflow was more than US$ 23 bn. A similar trend is being followedBy the real estate sector in terms of attracting FDI with the inflows falling by more than 60%In the first 10 months of 2010-11 to US$ 1 bn as compared to US$ 2.6 bn in correspondingperiod of previous year. Additionally, the share of real estate in total FDI inflow hasalso fallen drastically from 11% in 2009-10 to6% in 2010-11.The downturn of 2008 in the real estate market had resulted in many foreign investors losing large amount of investments in the country and this led to them becoming cautious towards committing further funds inThe sector. In addition to this, the recent scams and scandals that have hit the real estate sector along with the slowdown in demand in the residential segment may have resulted in investors turning averse towards investing in the sector. In order to analyze the performance of realEstate sector we have considered the financial results of 22 listed real estate companies in India on a quarterly basis. These 22 companies can be considered as a fair representative of the overall real estate market of India since it not only covers the various sub-segments of real estate but also all the major cities of India. The combined revenue of these companiesHas increased from Rs 146.6 bn in the first three quarters of 2009-10 to more thanRs 185.6 bn in the first three quarters of2010-11 resulting in a 27% year-on-yearIncrease. However, the concern is that the rate of growth in revenues has been reducingWith every passing quarter. From a high of48% year-on-year growth in Q1 2010-11, theRevenue growth rate has dropped to 29% and10% for Q2 2010-11 and Q3 2010-11Respectively. High prices in the luxury residential segment have resulted inSlowdown in demand in markets like Mumbai, NCR, Bangalore and Pune resultingin increased pressure on developers to reduce prices. However, none of these markets have witnessed any significant reduction in prices as of date which is leading to substantial build up in unsold inventory in this segment.
National Capital Region (NCR)
Year 2010 started on a favorable note for the NCR's residential segment. The IndianEconomy was showing positive signs of growth with the government projecting a healthy GDP growth rate for FY11. Job market had stabilized and consumer confidence wasIncreasing. The improvement witnessed in the Indian economy also had its impact onThe NCR's real estate sector. Housing inquiries began converting into actual sales
due to the increment of both investors and end user demand. Also, developers across NCR realized the sizeable demand present in the mid-segment housing and started launching projects in the affordable price bracket. Overall, the residential market in the NCR reflected a balance between demand and supply in 2010, as buyers were being offered housing projects that matched their price preference and also provided them with basic essential amenities.During 2010, developers across NCR ventured into new sectors in Noida, Greater Noida andGurgaon to take full advantage of low cost of land in the unexplored regions within NCRand at the same time, strived to pass on the benefit to the consumers by launchingprojects at affordable prices. Demand for housing in the NCR received further impetuswith the revival of the EMI on possession scheme and introduction of the flexi paymentplan. Though the flexi payment plan is designed in similar lines of the constructionlinked plan, it is supposed to further ease out liquidity pressure on the buyer as comparedto the earlier schemes. With the introduction of these two schemes along with reasonablypriced home loans rates, the demand for housing in NCR has been on the rise. Besides, to promote the image of the project, the developers also launched media campaigns highlighting a celebrity as the brand ambassador of the project, which acted as a key marketing tool for thedevelopers.Completion of phase 2 of the Delhi metro project also acted as a key growth factor, asimproved connectivity within the NCR made locations like Ghaziabad, Gurgaon and Noidamore attractive for home buyers. This increase in demand led prices across micro marketsto witness substantial appreciation. The negative impact of the global economicrecession witnessed in late 2008, had brought about a slump in the NCR'sresidential market. Demand was low, new launches were limited and work on existing projects were either stalled or construction was delayed. With the market reviving in2010, NCR residential sector, witnessed substantial activity in terms of re-initiating work on stalled projects and announcement of new projects. In response to growing consumer confidence as well as to meet the buyers' expectations, construction activity on projects was carried out at full swing.On the supply side, the NCR witnessed a good number of new locations being exploredby developers. New sectors 1 - 4 and 16B and16C in Greater Noida (collectively known asNoida Extension), Sectors 75 - 78 and 137 in Noida and sectors on the proposed NorthPeripheral road (NPR) in Gurgaon were explored by the developers for group housingdevelopment. A number of mid segment housing projects were launched in Q2 2010 inthese newer sectors of Noida, Greater Noida and Gurgaon. Projects like Paradise byMapsko Group, Spire South and Central by Spire World and Park wood West end byParkwood Group was launched in Gurgaon in the price range of Rs 2,250 - 2,876 /sq.ft.while Noida witnessed the launch of projects like Westeria by Prateek Builders, Kasa Islesby Jaypee Group, Karmic Green by Sikka Group and Blossom County by Logix Group,which were priced in the range ofRs 2,600 - 3,390/sq.ft.Early 2010 also witnessed a number of projectlaunches in Greater Noida. Projects like My wood by Mahagun Group, Eco Village bySuper tech Group, Golf Homes by Amrapaliand Gaur City by Gaur Developers werelaunched in the Noida Extension region. These projects were launched at a base priceof Rs. 1,880 - 2,335/sq.ft. Though the primary focus of the developers in2010 was to cater to the affordable segment,new projects launched in the premium
Category also drew the attention of the high end buyers. Key high-end projects such as Victory Valley by IREO, Golf Estate by M3M Group, Palm Terrance Select by EMAAR MGF and Presidiaby Pioneer Group witnessed ground breaking in 2010.All these projects are located in Gurgaon. In2010, DLF Group also launched the 3rd phase of its Capital Green project, a high-endresidential group housing development on Shivaji Marg in Delhi. Growing consumer confidence and a favorable economic scenario led to an increase in demand for residential propertieswhich in turn led residential capital values to rise across NCR? Locations in Delhi were theQuickest to respond to the improving market scenario, as the prices in South DelhiLocations started appreciating as early as Q12010. Jor Bagh and Chanakyapuri, some ofthe most expensive micro-markets in Delhi, witnessed a price appreciation of about 40%between Q4 2009 and Q1 2011. Similarly, South Delhi locations like Greater Kailas,Friends Colony and New Friends Colony witnessed price appreciation in the range of48- 52% during the same time. Micro-markets like Golf Course Road, Golf Course Extension and Sohna Road in witnessed substantial appreciation in prices in between Q4 2009 and Q1 2011.Prices in these locations increased in the range of 35-54%. Launch of high-end projects like Victory Valley and Golf Estate on Golf Course Extension were one of the key reasonsfor Gurgaon to witnesses such a substantial price appreciation. Matured micro-marketssuch as Indirapuram, Vaishali andVasundhara in Ghaziabad witnessed price.
Price TrendAppreciation in the range of about 26 - 34%during the period Q4 2009 and Q1 2011.Crossing Republic, an upcoming micromarketing Ghaziabad, witnessed an appreciation of only 9%, while Noida and Greater Noida witnessed price appreciation in the range of 3-10%. Limited price appreciation was observed in Noida and Greater Noida on account of the fact thatDuring 2010 many new sectors were explored by developers in these locations and projectsWere launched at affordable prices, which led to a marginal increase in capital values.Favorable market conditions, increase in demand for housing, new project launchesand considerable price appreciation were the key features of the NCR's residential segmentin 2010. Both investor and end user demand has been on the rise and construction activityacross NCR is being carried out at a fast pace. The Indian economy is expected to post morethan 9% GDP growth in the coming year and this will have a positive impact on the realestate market too. However, the unprecedented rise in prices of newly launched projects and the increase in interest rates on homes loans are expected to negatively impact the affordability of consumers in the market. Such a scenario wills ead to slowdown in demand for residential properties. Thus, while residential market is poised for a substantial growth in the forthcoming months, the increase in repo and reverse repo by the RBI could result in a further increase in home loan lending rates, thereby dampening the current pace of growth achieved by the NCR residential segment.
RBI BALANCING BETWEEN GROWTH AND INFLATION
The central banker of an emerging economy has the unenviable task of striking a balance between growth and inflation. They must not kill growth in the war on inflation. RBI Governor D Subbarao is one such governor. He represents the central bank of a leading emerging economy, where inflation is crawling up while growth is decelerating. On June 16, he made his mind clear when he had observed, “some short-term deceleration in growth may be unavoidable in bringing inflation under control and the RBI needs to persist with its anti-inflationary stance.”
What is noteworthy, however, about his ‘anti-inflationary stance’ is the small steps he takes, so that growth is not hurt. For this, he has earned criticism. According to critics of the baby steps, in the last 15 months the repo rate has been increased 10 times, by a cumulative 2.75 percentage points, but with little effect on inflation. There is, accordingly, a suggestion that RBI needs to re-think its strategy. However, such an assessment is misplaced.
So far, inflation was being driven largely by food and commodity prices, and RBI action could have had very little effect. Naturally, inflation was inching up, in spite of many hikes in the policy rate. Like central banks everywhere, the RBI had to take small steps to express its concern and readiness to act. While big steps could be damaging, baby steps could be intimidating. Further, so long as inflation was seen as a supply side constraint, there was no point in RBI displaying its killing spirit.
The context has changed now. Commodity price inflation has spread to manufactured products and is pushing core inflation. Couple this with food price inflation, and there is the risk of a wage-price spiral. Further, oil prices are posing a serious threat. If the government allows a full pass-through of the rise in oil prices, headline inflation would hover around the double-digit level and seriously cripple growth. Given this, it is time to declare war on inflation, before it spins out of control.
It is rightly felt that in the war on inflation, growth can wait. The RBI governor has once again increased the rate by only 25 basis points, but at 7.5 per cent the repo rate is sufficiently growth-constraining. Further hikes will follow if the present action is not seen to be effective enough.
However, the question of trade-off between inflation and growth still remains. We cannot ignore the interests of growth, as otherwise there is the risk of stagflation. Growth must wait at a level the economy can live with. What is that level where we can ask growth to wait and not fall further? What is the degree of freedom for the RBI with regard to rate hikes? What is the limit beyond which the rate should not be pushed further? It is difficult to answer such questions, but a realistic assessment of the current situation may be useful.
The global economy is once again in crisis, with the advanced economies standing on the precipice of stagnation. We, in India, cannot escape the effect of the crisis. The RBI governor is right in pointing out that “recent global macro economic developments pose some risks to domestic growth.” What he means is that our GDP growth will be affected in any case, and the situation may be worse if inflationary trends remain unabated. The question is, to what extent we can sacrifice growth and still retain the growth momentum?
During the crisis of 2008-09, our GDP growth had fallen to 6.8 per cent, but then, with the onset of recovery, it went up to 8 per cent in 2009-10 and 8.5 per cent in 2010-11. The slowdown fever had,
however, started, beginning in the second half of the last fiscal. In the fourth quarter of 2010-11, GDP growth declined to 7.8 per cent, from 8.3 per cent in the previous quarter. In the current year, no one, including the RBI, expects growth to be above 8 per cent. But it is imperative that we halt the deceleration, as we also try to contain inflation. It is important that we also provide a cover for the economy to achieve the minimal expectation of 8 per cent growth, or around 8.5 per cent. Take this as the benchmark for the current year. Will this be difficult to achieve, if the RBI goes in for a further rate hike of, say, 25 or 50 basis points? In my view, the RBI can have this leverage in controlling inflation and we can still have more than 8 per cent growth, provided some care is taken to ensure that the business environment is not disturbed and business confidence is boosted. At this moment, when the RBI has to perform its role, the government must ensure that the economy runs smoothly in spite of various anti-corruption drives and civil society movements. All centrally sponsored schemes need to be carried through in earnest so that resources allocated for the purpose are fully utilized. Intelligent fiscal consolidation also helps. It is also important to ensure that infrastructure projects are not hampered due to lack of clarity and uncertainty on matters relating to land, environment, forests, rehabilitation, etc. Such matters have been seriously hurting the investment climate in the country, and are contributing to the slowdown. On their part, commercial banks should be judicious in credit allocations. They may pursue a discretionary policy on supply of credit and lending rates. They have a critical role to play in this moment of crisis. Interest-sensitive but employment-intensive sectors (such as small and medium enterprises) can be spared the full rigors of the credit squeeze and the burden of high lending rates. In the war on inflation, the RBI and commercial banks can work in partnership. While the former controls inflation, the latter can protect growth.
Monetary policy by itself faces inherent limitations in tackling inflation in the absence of adequate supply side responses.
The Annual Report for 2010-11, a statutory publication of the Reserve Bank of India's central board, covers two broad areas — assessment of macro economy in 2010-11 as well as prospects for 2011-12 and working and operations of the RBI and its financial accounts.
The latest report released on August 25, like its predecessors, is a snapshot of the economy in the previous year even while it assesses its strengths and weaknesses during the current year.
Excerpts from the report covering growth prospects, inflation outlook and certain other aspects of the macro economy in the current year are given here.
The economy returned to a high growth path in 2010-11. However, there were significant challenges: investment slowed, fiscal consolidation was achieved through one-off and cyclical factors and inflation remained sticky on the back of new pressures.
In response, the RBI has raised the policy rates by 475 basis points (on a cumulative basis) since March, 2010. The central bank's medium-term target for inflation has been 3 per cent.
The current account deficit was contained within a reasonable limit, mainly due to an upswing in exports and a turnaround in invisibles.
Growth prospects
After growing slightly above its recent trend in 2010-11, the economy can be expected to decelerate this year. But quite significantly, the growth rate will still be around 8 per cent. However, there is a possibility of global problems getting magnified and imparting a ‘downward bias' to India's growth rate.
In general, growth prospects in the current year appear to be more subdued than last year. Apart from global uncertainties, high prices of oil and certain other commodities have a dampening effect. Other factors weighing on growth are persistent inflationary pressures, rising input costs, higher cost of capital (due to monetary tightening) and slow project execution.
While industrial growth may suffer because of loss of business confidence, the services sector is expected to make up for the shortfall and support the overall growth process.
Investment may remain soft in the near-term, while private consumption may decelerate. In the face of moderating demand, ‘expenditure switching' from government consumption expenditures to public investments would help. Inflation is expected to remain high and moderate only towards the latter part of the year to about 7 per cent by March, 2012. The decline in global commodity prices has not been significant so far. However, if the global recovery weakens further in the days ahead, commodity prices may fall and that may have a salutary effect on the Indian economy.
The ultra soft monetary policy pursued by the U.S. can keep commodity prices elevated. If the global oil prices stay at current levels, further increase in prices of administered oil prices will become necessary to control subsidies. Fertilizer and electricity prices will also require an upward revision in view of sharp rise in input costs.
Monetary policy by itself faces inherent limitations in tackling inflation in the absence of adequate supply side responses.
However, it can still play an important role in curbing the second round effects of supply-side inflation. In the face of nominal rigidities and price-stickiness, there are dangers of accepting the current elevated inflation level as the new normal.
The twin deficits
The fiscal deficit is likely to overshoot the budgeted provisions. If the economy slows down further as is anticipated, the erosion in revenue will magnify the fiscal slippage. Also, the space for counter-cyclical fiscal policies is more limited than it was at the time of the global crisis in 2008.
On a more positive side, the current account deficit (CAD) is expected to be contained within a sustainable 2.7-3 per cent of GDP. The export performance has been robust in 2010-11.
However, by all accounts exports are expected to slowdown later this year due to the deceleration in the advanced economies. Software exports too will be affected as bulk of them are to the U.S. and Europe.
Capital flows are more difficult to anticipate. Their ebb and flow depend on the degree of risk aversion. If the global crisis deepens, capital flows will moderate. However, capital flows can increase in spells on a relative return basis and due to interest differentials.
Medium-term challenges
The immediate challenge to sustaining high growth lies in bringing down inflation. Over the medium-term, however, growth can be sustained only by addressing the structural bottlenecks.
The medium-term challenges are: Lowering inflation and inflation outlook to acceptable levels; harnessing technology for agriculture productivity enhancements; maintaining right balance between consumption and investment; facilitating energy security; facilitating infrastructure finance; and promoting financial inclusion and inclusive growth.
In the war on inflation, the RBI and commercial banks can work in partnership. While the former controls inflation, the latter can protect growth
The central banker of an emerging economy has the unenviable task of striking a balance between growth and inflation. They must not kill growth in the war on inflation. RBI Governor D Subbarao is one such governor. He represents the central bank of a leading emerging economy, where inflation is crawling up while growth is decelerating. On June 16, he made his mind clear when he had observed, “some short-term deceleration in growth may be unavoidable in bringing inflation under control and the RBI needs to persist with its anti-inflationary stance.”
What is noteworthy, however, about his ‘anti-inflationary stance’ is the small steps he takes, so that growth is not hurt. For this, he has earned criticism. According to critics of the baby steps, in the last 15 months the repo rate has been increased 10 times, by a cumulative 2.75 percentage points, but with little effect on inflation. There is, accordingly, a suggestion that RBI needs to re-think its strategy. However, such an assessment is misplaced.
So far, inflation was being driven largely by food and commodity prices, and RBI action could have had very little effect. Naturally, inflation was inching up, in spite of many hikes in the policy rate. Like central
banks everywhere, the RBI had to take small steps to express its concern and readiness to act. While big steps could be damaging, baby steps could be intimidating. Further, so long as inflation was seen as a supply side constraint, there was no point in RBI displaying its killing spirit?
The context has changed now. Commodity price inflation has spread to manufacture products and is pushing core inflation. Couple this with food price inflation, and there is the risk of a wage-price spiral. Further, oil prices are posing a serious threat. If the government allows a full pass-through of the rise in oil prices, headline inflation would hover around the double-digit level and seriously cripple growth. Given this, it is time to declare war on inflation, before it spins out of control.
It is rightly felt that in the war on inflation, growth can wait. The RBI governor has once again increased the rate by only 25 basis points, but at 7.5 per cent the repo rate is sufficiently growth-constraining. Further hikes will follow if the present action is not seen to be effective enough.
However, the question of trade-off between inflation and growth still remains. We cannot ignore the interests of growth, as otherwise there is the risk of stagflation. Growth must wait at a level the economy can live with. What is that level where we can ask growth to wait and not fall further? What is the degree of freedom for the RBI with regard to rate hikes? What is the limit beyond which the rate should not be pushed further? It is difficult to answer such questions, but a realistic assessment of the current situation may be useful.
The global economy is once again in crisis, with the advanced economies standing on the precipice of stagnation. We, in India, cannot escape the effect of the crisis. The RBI governor is right in pointing out that “recent global macro economic developments pose some risks to domestic growth.” What he means is that our GDP growth will be affected in any case, and the situation may be worse if inflationary trends remain unabated. The question is, to what extent we can sacrifice growth and still retain the growth momentum?
During the crisis of 2008-09, our GDP growth had fallen to 6.8 per cent, but then, with the onset of recovery, it went up to 8 per cent in 2009-10 and 8.5 per cent in 2010-11. The slowdown fever had, however, started, beginning in the second half of the last fiscal. In the fourth quarter of 2010-11, GDP growth declined to 7.8 per cent, from 8.3 per cent in the previous quarter. In the current year, no one, including the RBI, expects growth to be above 8 per cent. But it is imperative that we halt the deceleration, as we also try to contain inflation. It is important that we also provide a cover for the economy to achieve the minimal expectation of 8 per cent growth, or around 8.5 per cent.
Take this as the benchmark for the current year. Will this be difficult to achieve, if the RBI goes in for a further rate hike of, say, 25 or 50 basis points? In my view, the RBI can have this leverage in controlling inflation and we can still have more than 8 per cent growth, provided some care is taken to ensure that the business environment is not disturbed and business confidence is boosted.
At this moment, when the RBI has to perform its role, the government must ensure that the economy runs smoothly in spite of various anti-corruption drives and civil society movements. All centrally sponsored schemes need to be carried through in earnest so that resources allocated for the purpose are fully utilized. Intelligent fiscal consolidation also helps. It is also important to ensure that infrastructure projects are not hampered due to lack of clarity and uncertainty on matters relating to
land, environment, forests, rehabilitation, etc. Such matters have been seriously hurting the investment climate in the country, and are contributing to the slowdown.
On their part, commercial banks should be judicious in credit allocations. They may pursue a discretionary policy on supply of credit and lending rates. They have a critical role to play in this moment of crisis. Interest-sensitive but employment-intensive sectors (such as small and medium enterprises) can be spared the full rigors of the credit squeeze and the burden of high lending rates. In the war on inflation, the RBI and commercial banks can work in partnership. While the former controls inflation, the latter can protect growth.
Monetary Aggregates
During 2009-10, money supply (M3) growth decelerated from over 20.0 per cent at the beginning of the financial year to 16.4 per cent in February 2010 before increasing to 16.8 per cent by March 2010, slightly above the Reserve Bank’s indicative projection of 16.5 per cent. This was reflected in non-food credit growth of 16.9 per cent, above the indicative projection of 16.0 per cent. Keeping in view the need to balance the resource demand to meet credit offtake by the private sector and government borrowings, monetary projections have been made consistent with the growth and inflation outlook. For policy purposes, M3 growth for 2010-11 is placed at 17.0 per cent. Consistent with this, aggregate deposits of SCBs are projected to grow by 18.0 per cent. The growth in non-food credit of SCBs is placed at 20.0 per cent. As always, these numbers are provided as indicative projections and not as targets.
Risk Factors
While the indicative projections of growth and inflation for 2010-11 may appear reassuring, the following major downside risks to growth and upside risks to inflation need to be recognized:First, uncertainty persists about the pace and shape of global recovery. Fiscal stimulus measures played a major role in the recovery process in many countries by compensating for the fall in private demand. Private demand in major advanced economies continues to be weak due to high unemployment rates, weak income growth and tight credit conditions. There is a risk that once the impact of public spending wanes, the recovery process will be stalled. Therefore, the prospects of sustaining the recovery hinge strongly on the revival of private consumption and investment. While recovery in India is expected to be driven predominantly by domestic demand, significant trade, financial and sentiment linkages indicate that a sluggish and uncertain global environment can adversely impact the Indian economy.
Second, if the global recovery does gain momentum, commodity and energy prices, which have been on the rise during the last one year, may harden further. Increase in global commodity prices could, therefore, add to inflationary pressures.
Third, from the perspective of both domestic demand and inflation management, the 2010 south-west monsoon is a critical factor. The current assessment of softening of domestic inflation around mid-2010 is contingent on a normal monsoon and moderation in food prices. Any unfavourable pattern in spatial and temporal distribution of rainfall could exacerbate food inflation. In the current context, an unfavourable monsoon could also impose a fiscal burden and dampen rural consumer and investment demand.
Fourth, it is unlikely that the large monetary expansion in advanced economies will be unwound in the near future. Accommodative monetary policies in the advanced economies, coupled with better growth prospects in EMEs including India, are expected to trigger large capital flows into the EMEs. While the absorptive capacity of the Indian economy has been increasing, excessive flows pose a challenge for exchange rate and monetary management. The rupee has appreciated sharply in real terms over the past one year. Pressures from higher capital flows combined with the prevailing rate of inflation will only reinforce that tendency. Both exporters, whose prospects are just beginning to turn, and producers, who compete with imports in domestic markets, are getting increasingly concerned about the external sector dynamics.
Our exchange rate policy is not guided by a fixed or pre-announced target or band. Our policy has been to retain the flexibility to intervene in the market to manage excessive volatility and disruptions to the macroeconomic situation. Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances. There is, therefore, a need to be vigilant against the build-up of sharp and volatile exchange rate movements and its potentially harmful impact on the real economy. The resumption of the process of fiscal consolidation has been a significant positive development. This will help avoid crowding out of private sector credit demand and facilitate better monetary management. However, the overall size of the government borrowing programmed is still very large and can exert pressure on interest rates. Going forward, fiscal consolidation has to shift from one-off gains to structural improvements on both tax and expenditure sides, and focus increasingly on the quality of fiscal consolidation.
The Policy Stance
In the wake of the global economic crisis, the Reserve Bank pursued an accommodative monetary policy beginning mid-September 2008. This policy instilled confidence in market participants, mitigated the adverse impact of the global financial crisis on the economy and ensured that the economy started recovering ahead of most other economies. However, in view of the rising food inflation and the risk of it impinging on inflationary expectations, the Reserve Bank embarked on the first phase of exit from the expansionary monetary policy by terminating some sector-specific liquidity facilities and restoring the statutory liquidity ratio (SLR) of scheduled commercial banks to its pre-crisis level in the Second Quarter Review of October 2009.
The process was carried forward by the second phase of exit when the Reserve Bank announced a 75 basis points increase in the CRR in the Third Quarter Review of January 2010. As inflation continued to increase, driven significantly by the prices of non-food manufactured goods, and exceeded the Reserve Bank’s baseline projection of 8.5 per cent for March 2010 (made in the
Third Quarter Review), the Reserve Bank responded expeditiously with a mid-cycle increase of 25 basis points each in the policy repo rate and the reverse repo rate under the LAF on March 19, 2010.
The monetary policy response in India since October 2009 has been calibrated to India’s specific macroeconomic conditions. Accordingly, our policy stance for 2010-11 has been guided by the following three major considerations:
First, recovery is consolidating. The quick rebound of growth during 2009-10 despite failure of monsoon rainfall suggests that the Indian economy has become resilient. Growth in 2010-11 is projected to be higher and more broad-based than in 2009-10. In its Third Quarter Review in January 2010, the Reserve Bank had indicated that our main monetary policy instruments are at levels that are more consistent with a crisis situation than with a fast recovering economy. In the emerging scenario, lower policy rates can complicate the inflation outlook and impair inflationary expectations, particularly given the recent escalation in the prices of non-food manufactured items. Despite the increase of 25 basis points each in the repo rate and the reverse repo rate, our real policy rates are still negative. With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalizing our policy instruments.
Second, inflationary pressures have accentuated in the recent period. More importantly, inflation, which was earlier driven entirely by supply side factors, is now getting increasingly generalized. There is already some evidence that the pricing power of corporate has returned. With the growth expected to accelerate further in the next year, capacity constraints will re-emerge, which are expected to exert further pressure on prices. Inflation expectations also remain at an elevated level. There is, therefore, a need to ensure that demand side inflation does not become entrenched.
Third, notwithstanding lower budgeted government borrowings in 2010-11 than in the year before, fresh issuance of securities will be 36.3 per cent higher than in the previous year. This presents a dilemma for the Reserve Bank. While monetary policy considerations demand that surplus liquidity should be absorbed, debt management considerations warrant supportive liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government borrowing programmed is not hampered.
Against this backdrop, the stance of monetary policy of the Reserve Bank is intended to:
Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures.
Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way.
Maintain an interest rate regime consistent with price, output and financial stability.
Monetary Measures
On the basis of the current assessment and in line with the policy stance as outlined in Section III, the Reserve Bank announces the following policy measures:
Bank Rate
The Bank Rate has been retained at 6.0 per cent.
Repo Rate
It has been decided to:
Increase the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.0 per cent to 5.25 per cent with immediate effect.
Reverse Repo Rate
It has been decided to:
Increase the reverse repo rate under the LAF by 25 basis points from 3.5 per cent to 3.75 per cent with immediate effect.
Cash Reserve Ratio
It has been decided to:
Increase the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 5.75 per cent to 6.0 per cent of their net demand and time liabilities (NDTL) effective the fortnight beginning April 24, 2010.
As a result of the increase in the CRR, about Rs. 12,500 crore of excess liquidity will be absorbed from the system.
The Reserve Bank will continue to monitor macroeconomic conditions, particularly the price situation, closely and take further action as warranted.
Expected Outcomes
49. The expected outcomes of the actions are:
(i) Inflation will be contained and inflationary expectations will be anchored.(ii) The recovery process will be sustained. (iii) Government borrowing requirements and the private credit demand will be met. (iv) Policy instruments will be further aligned in a manner consistent with the evolving state of the economy.
First Quarter Review of Monetary Policy 2010-11
The First Quarter Review of Monetary Policy for 2010-11 will be announced on July 27, 2010.
Part B. Development and Regulatory Policies
The global financial crisis has underscored the importance of pursuing financial sector policies in the broader context of financial stability and to serve the interests of the real economy. A major lesson is that no indicator or action is foolproof, which points to the need for continuous monitoring, regular review of processes, proactive oversight and pre-emptive actions. Thus, periodic assessment of regulatory comforts and effective supervision are critical elements for developing the financial sector on a sound footing.
Over the last several years, the Reserve Bank has undertaken wide-ranging financial sector reforms to improve financial intermediation and maintain financial stability. This process has now become more intensive with a focus on drawing appropriate lessons from the global financial crisis and putting in place a regulatory regime that is alert to possible build-up of financial imbalances. The focus of the Reserve Bank’s regulation will continue to be to improve the efficiency of the banking sector while maintaining financial stability. Simultaneously, it will vigorously pursue the financial inclusion agenda to make financial sector development more inclusive.
A synopsis of the action taken on the past policy announcements together with a list of fresh policy measures is set out below.
Financial Stability
Financial Stability Report
As announced in the Annual Policy Statement of April 2009, the Reserve Bank established a Financial Stability Unit in August 2009 for carrying out periodic stress testing and for preparing financial stability reports.
The first Financial Stability Report (FSR) was released on March 25, 2010. This Report is an attempt at institutionalizing the focus on financial stability and making it an integral part of the policy framework. The first FSR makes an assessment of the strength of the financial sector, with particular focus on banks, and has raised some concerns, including rising inflation, high government borrowings and likely surge in capital flows, from the financial stability standpoint. The FSR observed that the banks remained well-capitalized with higher core capital and sustainable financial leverage. Further, stress tests for credit and market risk confirmed banks’ resilience to withstand high stress. The FSR also emphasized the need for evolving a stronger supervisory regime for systemically important non-deposit taking non-banking financial companies (NBFCs-ND-SI) and strengthening the monitoring and oversight framework for systemically important financial conglomerates. Overall risk to financial stability was found to be limited. However, the recent financial turmoil has clearly demonstrated that financial stability cannot be taken for granted, and that the maintenance of financial stability requires constant vigilance, especially during normal times to detect and mitigate any incipient signs of instability. Going forward, the Financial Stability Reports will be published half-yearly.
Interest Rate Policy
Base Rate: Introduction
As indicated in the Annual Policy Statement of April 2009, the Reserve Bank constituted a Working Group on Benchmark Prime Lending Rate (Chairman: Shri Deepak Mohanty) to review the present benchmark prime lending rate (BPLR) system and suggest changes to make credit pricing more transparent. The Working Group submitted its report in October 2009 and the same was placed on the Reserve Bank’s website for public comments. Based on the recommendations of the Group and the suggestions from various stakeholders, the draft guidelines on Base Rate were placed on the Reserve Bank’s website in February 2010.In the light of the comments/suggestions received, it has been decided to mandate banks to switch over to the system of Base Rate from July 1, 2010. Guidelines on the Base Rate system were issued on April 9, 2010. It is expected that the Base Rate system will facilitate better pricing of loans, enhance transparency in lending rates and improve the assessment of transmission of monetary policy.
Financial Markets
Financial Market Products
Interest Rate Futures
The Interest Rate Futures contract on 10-year notional coupon bearing Government of India security was introduced on August 31, 2009. Based on the market feedback and the recommendations of the Technical Advisory Committee (TAC) on the Money, Foreign Exchange and Government Securities Markets, it is proposed:
To introduce Interest Rate Futures on 5-year and 2-year notional coupon bearing securities and 91-day Treasury Bills. The RBI-SEBI Standing Technical Committee will finalise the product design and operational modalities for introduction of these products on the exchanges.
Regulation of Non-Convertible Debentures (NCDs) of Maturity of Less than One Year
As indicated in the Second Quarter Review of October 2009, the draft guidelines on the regulation of non-convertible debentures (NCDs) of maturity of less than one year were placed on the Reserve Bank’s website on November 3, 2009 for comments/feedback. The
comments/feedback received were examined and also deliberated by the TAC on the Money, Foreign Exchange and Government Securities Markets. Accordingly, it is proposed:
To issue the final guidelines on the issuance of NCDs of maturity less than one year by end-June 2010.
Introduction of Credit Default Swaps (CDS)
As indicated in the Second Quarter Review of October 2009, the Reserve Bank constituted an internal Working Group to finalize the operational framework for introduction of plain vanilla over-the-counter (OTC) single-name CDS for corporate bonds for resident entities subject to appropriate safeguards. The Group is in the process of finalizing a framework suitable for the Indian market, based on consultations with market participants/experts and study of international experience. Accordingly, it is proposed:
To place the draft report of the internal Working Group on the Reserve Bank’s website by end-July 2010.
Guidelines on Forex Derivatives
As indicated in the Second Quarter Review of October 2009, the draft guidelines on OTC foreign exchange derivatives were placed on the Reserve Bank’s website on November 12, 2009 for public comments. The feedback received from stakeholders and industry associations was discussed in the meeting of the TAC on the Money, Foreign Exchange and Government Securities Markets. On the basis of the discussions, it is proposed:
To issue final guidelines by end-June 2010.
Introduction of Exchange-Traded Currency Option Contracts
Currently, residents in India are permitted to trade in futures contracts in four currency pairs on two recognized stock exchanges. In order to expand the menu of tools for hedging currency risk, it has been decided:
to permit the recognized stock exchanges to introduce plain vanilla currency options on spot US Dollar/Rupee exchange rate for residents.
The risk management and operational guidelines will be finalized by the RBI-SEBI Standing Technical Committee.
Separate Trading for Registered Interest and Principal of Securities (STRIPS): Status
As indicated in the Annual Policy Statement for 2009-10, the draft guidelines on stripping/reconstitution of government securities prepared in consultation with market participants were placed on the Reserve Bank’s website on May 14, 2009 for comments and feedback. Taking into consideration the feedback received on the draft guidelines, the final
guidelines on stripping/reconstitution of government securities were issued on March 25, 2010. The guidelines, which came into effect from April 1, 2010, will enable market participants to strip/reconstitute eligible Government of India dated securities through the negotiated dealing system (NDS) subject to certain terms and conditions.
Corporate Bond Market
In the recent period, the Reserve Bank initiated several measures to develop the corporate bond market as detailed below:
(i) To facilitate settlement of secondary market trades in corporate bonds on a delivery versus payment-1 (DVP-1) basis on the Real Time Gross Settlement (RTGS) system, the National Securities Clearing Corporation Limited (NSCCL) and the Indian Clearing Corporation Limited (ICCL) have been permitted to maintain transitory pooling accounts with the Reserve Bank. Further, guidelines have been issued to all Reserve Bank regulated entities to mandatorily clear and settle all OTC trades in corporate bonds using the above arrangement with effect from December 1, 2009.
(ii) To facilitate the development of an active repo market in corporate bonds, the guidelines for repo transactions in corporate debt securities were issued on January 8, 2010. The guidelines, which came into force with effect from March 1, 2010, will enable repo in listed corporate debt securities rated ‘AA’ or above. Fixed Income Money Market and Derivatives Association of India (FIMMDA) is working on the development of reporting platform and also on the Global Master Repo Agreement to operationalise the repo in corporate bonds.
Non-SLR Bonds of companies engaged in infrastructure: Valuation
At present, banks’ investments in non-SLR bonds are classified either under held for trading (HFT) or available for sale (AFS) category and subjected to ‘mark to market’ requirements. Considering that the long-term bonds issued by companies engaged in infrastructure activities are generally held by banks for a long period and not traded and also with a view to incentivizing banks to invest in such bonds, it is proposed:
To allow banks to classify their investments in non-SLR bonds issued by companies engaged in infrastructure activities and having a minimum residual maturity of seven years under the held to maturity (HTM) category.
Investment in Unlisted Non-SLR Securities
In terms of extant instructions, banks’ investments in unlisted non-SLR securities should not exceed 10 per cent of their total investments in non-SLR securities as on March 31 of the previous year. Since there is a time lag between issuance and listing of security, banks may not be able to participate in primary issues of non-SLR securities, which are proposed to be listed but not listed at the time of subscription. In view of the above, it is proposed that:
Investment in non-SLR debt securities (both primary and secondary market) by banks where the security is proposed to be listed on the Exchange(s) may be considered as investment in listed security at the time of making investment.
If such security, however, is not listed within the period specified, the same will be reckoned for the 10 per cent limit specified for unlisted non-SLR securities. In case such investment included under unlisted non-SLR securities lead to a breach of the 10 per cent limit, the bank would not be allowed to make further investment in non-SLR securities (both primary and secondary market, including unrated bonds issued for financing infrastructure activities) till such time the limit is reached.
CONCLUSION
The current inflation scenario is a cause of concern, as the inflation rate persists well above the upper bound of the comfort zone. The fact that these inflationary pressures emerged rather quickly in a situation in which the economy was just beginning to recover from the significant slowdown of 2008-09 made the policy challenge more complicated. The monetary policy response to these pressures has been a calibrated one, seeking a balance between sustaining the recovery and reining in inflation, while being mindful of the risks that still remain in the global environment. Recent data suggest that the approach is working, with the economy set to grow at a reasonably healthy rate during the current year and the inflation rate beginning to decline, including, significantly, in the manufacturing sector, where inflation is seen as being most responsive to monetary actions.
This approach must be viewed in the context of a long-standing policy commitment to maintain a balance between growth and inflation in the short run, while fostering faster growth with lower inflation over long periods of time. The growth pattern of the Indian economy over the past six decades clearly shows that accelerating growth has been accompanied by declining inflation. This is primarily because growth has been driven by expanding capacities across the board as well as, in recent years, by increasing global linkages. Both these factors have helped to achieve a strong supply response to growing demand, thus keeping inflation in check.
This is not to say that the Indian economy is now invulnerable to inflation shocks. Food and energy price shocks have been a regular part of the economic landscape and may continue to be so in the future. Food prices, in particular, are now being driven by some structural imbalances between demand and supply, as increasingly affluent consumers diversify their dietary patterns away from cereals and
towards protein sources. This calls for an effort to quickly increase the availability of these items, on which is contingent the longer term outlook for food price inflation.
However, over the years, both fiscal and monetary policy approaches have clearly assimilated the lessons of the past and have moved in a direction which helps contain inflationary pressures even as growth remains robust. Making inflation low and stable was the outcome of a combination of long-term and short-term policies over the past decades. Keeping it there remains the objective, while an appropriate combination of long-term and short-term policies will provide the instrument to achieve it.