Third Quarter Review Of Monetary Policy

Monetary Policy 3rd Quarter - 2008 - 09

Business Environment

Third Quarter Review of Monetary Policy (2008-09) The third quarter monetary policy in basically formulated in context of the deteriorating global economic outlook and heightened uncertainty about the global financial sector. There has been a marked and rapid downturn in the global economic outlook since the mid-term review by RBI and hence with continued bad news from large financial institutions on a regular basis, it has been necessary to renew the monetary policy and as to when the global financial sector would stabilize.

Since India is integrated into the global system and had global linkages with the rest of the world, not only in trade terms but also through flow of money between India and other countries. And just because of this simple reason India cannot remain untouched or unaffected from the global crisis and hence India has to face uncertainty like the rest of the world. This Global crisis is affecting India in several ways. It has been observed that in first half of the financial year, i.e. in 200809, the inflation rate was very high. But as a result of slowdown the inflations rates have started falling down drastically. The global financial crisis, economic slowdown, and falling commodity prices affected the Indian economy in several ways: a. Capital Flow Reversals intensified in September – October 2008. b. Industrial production growth has slackened. c. Export growth has turned negative during October – November 2008.

d. International credit channels continued to be constrained. e. Capital market valuations remained low. f. And overall business sentiments have deteriorated. But on the flip-side, a. Inflation has come down. b. Domestic financial markets are functioning in orderly manner. Although bank credit is higher than during the previous year, rough calculation shows that flow of overall financial resources to the commercial sector in the current financial year has declined marginally as compared with the previous year. This was on account of decline in other sources of funding such as resource mobilisation from the capital market and external commercial borrowings. With all this both the Government and the RBI have acted promptly since September so as to avoid the adverse impact of the crisis. Government announced two major fiscal packages, while RBI took measures to provide ample rupee liquidity, ensure comfortable dollar liquidity and maintain a monetary policy environment conducive for the continued flow of credit to productive sectors i.e. it ensured that the sectors which are productive should not be hit by the global crisis thus RBI took measures to pump in ample liquidity so that these sectors keep on growing. However, the measures aimed at increasing the rupee liquidity include:a. A significant reduction in Cash Reserve Ratio, b. A special repo window under Liquid Adjustment Facility for i.

Banks for on-lending to mutual funds (MFs),

ii.

Non-banking financial companies (NBFCs), and

iii. c.

Housing finance companies (HFCs).

A special refinance facility that banks can access without any collateral.

d. In addition, a Special purpose vehicle (SPV) has been set up to provide liquidity support to non-banking financial companies (NBFCs). Measures aimed at managing foreign exchange include:a. Upward adjustment of the interest rate ceilings on i. the foreign currency non-resident (banks)

[FCNR(B)], ii. Non- Resident (external) rupee account

[NR(E)RA] deposits. b. Substantially relaxation of the external commercial borrowings (ECB) regime, allowing NBFCs/HFCs access to foreign borrowing. c. Allowing corporates to buy back foreign currency convertible bonds (FCCBs) to take advantage of the discount in the prevailing depressed global markets. d. The Reserve Bank has also instituted a rupeedollar swap facility for banks with overseas branches to give them comfort in managing their short-term funding requirements. Measures to encourage flow of credit to the sectors which were coming under pressure included:a. Extending the period of pre-shipment and postshipment credit for exports, b. Expanding the refinance facility for exports, c. Counter-cyclical adjustment of provisioning norms for all types d. of standard assets barring some exceptions, e. Reducing risk weights on banks' exposure to certain sectors which had been increased earlier countercyclically, and f. Expanding the lendable resources available to the Small Industries Development Bank of India (SIDBI), the

National Housing Bank (NHB) and the Export-Import (EXIM) Bank of India. In order to improve the flow of credit to the productive sector and that too at the viable costs, RBI lowered the interest rate structure by reducing both the Repo Rate and the Reverse Repo Rate. The statutory liquidity ratio (SLR) was also reduced by one percentage point releasing funds to banks for credit deployment. The several measures taken in mid – September 2008 resulted in augmentation of actual/potential liquidity of Rs. 3,88,000 crore, improving the liquidity condition. However, the permanent reduction in Statutory Liquidity Ratio by 1% of Net Demand and Time liabilities made Rs. 40,000 crore for the purpose of credit expansion. The liquidity condition improved significantly with the measures taken up by Reserve Bank of India. The call money market rate, which was earlier higher than the repo rate in September – October 2008, fell down significantly since early November 2008. Other money market rates also fell down with the fall in call money rates. The problems faced by mutual funds appeared to have been eased with the LAF corridor being in the absorption mode since mid – November 2008. In order to promote liquidity there was a record cut in repo and reverse repo rate in just one quarter i.e. repo rate fell down from 9% to 5.5% and the reverse repo rate from 6% to 4%. The demand for credit from the banking sector has increased as other sources of funds to the commercial sector have shrunk. Available information (as on January 23, 2009) suggests that the total flow of resources to the commercial sector from all sources, estimated at about Rs.4,85,000 crore, has been lower than about Rs.4,99,000 crore in the corresponding period of the previous year. While bank credit has substituted for the shortfall in other sources of funds to some extent, a complete substitution has so far not taken place. The Reserve Bank’s Mid – Term Review of October 2008, estimated real GDP growth for 2008-09 in the range 7.5 – 8%, but because of risks to growth have been increased as a result of slowdown in the Industrial activity and also weakness in the Exports. Service sector, also, is bound to be affected by this

and hence is likely to decelerate in second half of 2008 – 09. Keeping in view the slowdown in industry and services and with the assumption of normal agricultural production, the projection of overall real GDP growth for 2008-09 is revised downwards to 7.0 per cent. There has been a marked decline in prices of the commodities around the world as a result of pressures on the prices due to slump in world’s demand of different commodities. Inflation in terms of wholesale price index has already been below 7% and is expected to moderate further in last quarter of 2008 -09. Keeping in view the global trend in commodity prices and the domestic demand-supply balance, WPI inflation is now projected to decelerate to below 3.0 per cent by end-March 2009. In lieu of moderation in economic growth, it becomes critical that banks should expand the flow of credit to the productive sectors of the economy and that too at a viable rate. At the same time banks should monitor their loan portfolios and take early action to prevent any shortfall to meet obligations which hampers asset quality. The Reserve Bank appreciates that risk management is a difficult task in normal circumstances; it is even more challenging in an environment of uncertainty and downturn. Towards this shared endeavour of maintaining the flow of credit to productive sectors, the Reserve Bank will take calibrated monetary policy actions as necessary and at the appropriate time. Besides the origin of crisis is same across the world, however, it has hit different economies differently. In advanced economies i.e. from where it has originated, the crisis has spread from financial sector to real sector. But in emerging economies, with the effect from the external shocks it has shown the reverse trend and the crisis had shifted from real sector to financial sector. In particular, while policy responses in advanced economies have had to contend with both the financial crisis and recession, in India, the policy response has been predominantly driven by the need to arrest moderation in economic growth. Our ability to respond has been facilitated by the continued

smooth functioning of our financial markets and the wellcapitalised and healthy banking system. Thus, even as policy responses across countries are broadly similar, their precise design, quantum, sequencing and timing have varied. This has been the case with India too. While we have certainly studied and evaluated measures taken by other central banks around the world, we have calibrated and designed our responses keeping in view India's specific economic context.