Description
RBI's Monetary policies from 2008-2011
IMPACT OF RBI'S MONETARY POLICIES ON OVERALL ECONOMIC GROWTH, INDUSTRIAL PRODUCTION DURING 2008-11
Submitted By Rahul S Roll No : 11DM116 Section B, PGDM
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ACKNOWLEGEMENT
We would like to show our greatest appreciation to our Prof. Jagdish Shettigar. We can¶t thank him enough for his tremendous support and help throughout the period of making of this report. Without his encouragement and guidance this project would not have materialized.
The research and study done during the preparation of this report helped us to have an insight about the monetary policies of RBI and their impact on inflation.
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CONTENTS
1.
Introduction ........................................................................................ 1
2. Monetary Policy .................................................................................. 2 3. Impact of Monetary Policy on Economic Growth ............................ 3 4. Impact of Monetary Policy on Industrial Growth ............................ 5 5. Monetary policy 2008-09 .................................................................... 6 6. Monetary policy 2009-10 .................................................................. 11 7. Monetary policy 2010-11 .................................................................. 16 8. Bibliography ..................................................................................... 22
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INTRODUCTION
By monetary policy, we mean policy concerned with changes in the supply of money. Issues connected with monetary policy are: objectives or goals of the policy, instruments of monetary control, its efficacy, implementation, intermediate target of the policy etc. India¶s monetary policy since the first plan period was one of 'controlled expansion¶- that is, a policy of adequate financing of economic growth ensuring reasonable price stability. Thus, RBI helped the economy to expand via expansion of money and credit and attempted to check rise in prices through monetary and other control measures. A mild version of the liberalization process in the Indian economy was initiated in the mid 1980s. But, it lacked depth, coverage and self sustaining character. During the far end of the 1980¶s the economy suffered a big jolt with the eruption of a major macro-economic crisis. It manifested initially in the form of foreign exchange crisis, and then debt and interest payment problems. To meet the crisis India approached the World Bank and the International Monetary Fund (IMF) for a big loan. For granting the loan, World Bank and the IMF stipulated certain conditions. Since India was in a critical situation, she accepted the conditions of the World Bank and the IMF and then provided an immediate context for the realignment of the macro-economic fundamentals, through a programme of economic stabilization. With this end in view, India initiated the new economic policy in July 1991. The package of economic reforms, which are expected to have long-term impact on the economy, includes fiscal, monetary, financial, and industrial and export-import (EXIM) sector reforms. The reforms in monetary and credit policies aimed at slowing down monetary expansion and thereby controlling inflation. The financial sector reforms were initiated on the recommendations of Narasimham Committee Report. The first phase of reform started with a reduction of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) and permitted a degree of flexibility to the banks in the matter of deposit interest rates. Money markets facilitate the conduct of monetary policy in a country. The development of money market in India in the last few years has been facilitated by some major factors. Firstly, it permitted a gradual de-emphasis on cash reserve ratio as a monetary policy instrument.
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Secondly, the development of an array of instruments of indirect monetary control, such as, the Bank Rate and the Liquidity Adjustment Facility (LAF). Thirdly, monetary policy is often, shaped by developments in the money and the foreign exchange markets. MONETARY POLICY: Monetary policy is the process by which the government, central bank, or monetary authority of a country controls y y y The supply of money Availability of money Cost of money or interest rates
to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate to achieve policy goals. A monetary policy can be either Expansionary or Contractionary. It is referred to as Expansionary if it increases the supply of money in the economy by decreasing the interest rates. It is referred to as Contractionary if it lowers the supply of money in the economy by increasing the interest rates. The primary tool of monetary Policy is Open Market Operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.
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It is the Central bank that influences interest rates by expanding or contracting the monetary base by way of open market operations. IMPACT OF MONETARY POLICY ON ECONOMIC GROWTH: There are two different views on what effect a Monetary policy can have on the country¶s GDP. Monetarists¶ view: It argues that the demand for money is stable and is not very sensitive to changes in the rate of interest. Hence, expansionary monetary policies only serve to create a surplus of money that households will quickly spend, thereby increasing aggregate demand. Unlike classical economists, monetarists acknowledge that the economy may not always be operating at the full employment level of real GDP. Thus, in the short-run, monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand. However, in the long-run, when the economy is operating at the full employment level, monetarists argue that the classical quantity theory remains a good approximation of the link between the supply of money, the price level, and the real GDP. According to this theory, an increase (decrease) in the quantity of money leads to a proportional increase (decrease) in the price level. The quantity theory of money is usually discussed in terms of the equation of exchange, which is given by the expression MV=PY Where M: money supply V: Velocity of money P: Price level Y: Level of current GDP Classical economists assume that Y in the equation of exchange is fixed, at least in the short-run. Furthermore, classical economists argue that the velocity of circulation of money tends 3
to remain constant so that V can also be regarded as fixed. Assuming that both Y and V are fixed, it follows that in case of expansionary (or contractionary) monetary policy, leading to an increase (or decrease) in M, would only lead to an increase (or decrease) the price level, P, in direct proportion to the change in M. Thus, in the long-run, monetary policies only lead to inflation or deflation and do not affect the level of real GDP. Keynesian view: does not believe in the direct link between the supply of money and the price level that emerges from the classical quantity theory of money. They reject the notion that the economy is always at or near the natural level of real GDP so that Y in the equation of exchange can be regarded as fixed. They also reject the proposition that the velocity of circulation of money is constant. Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system, causing interest rates to fall. With lower interest rates, aggregate expenditures on investment and interest-sensitive consumption goods usually increase, causing real GDP to rise. Hence, monetary policy can affect real GDP indirectly. IMPACT OF MONETARY POLICY ON INDSUTRIAL PRODUCTION: Monetary policy affects Industrial production through its effect on interest rates which determines the cost of borrowing for investors. For ex., the influencing of the interest rate by the Central Bank through announcing targets for benchmark interest rates determines the cost of funds for financial institutions and hence the rates at which they are willing to lend. Higher interest rates lower the net rates of return for investment projects and projects with lower gross rates of return are not initiated. Similarly, expansionary monetary policy lowers the cost of borrowing via lower interest rates and allows projects with lower rates of return to be profitable. RBI¶S APPROACH TO MONETARY POLICY: The RBI conducts Monetary Policy by announcing targets for its benchmark lending rates wiz. repo & reverse repo rates and the bank rate. It then intervenes in the Bond Market to achieve the announced rates. The RBI¶s Monetary Policy from 2008-2011 must be understood in the backdrop of the massive sterilized interventions in the currency market that the RBI undertook 4
2003 onwards which has led to a massive accumulation of µMarket Stabilization Scheme¶ bonds, the servicing of which has led to a direct expansion of the RBI¶s Balance Sheet. The sheer accumulated volume of these bonds has led the RBI to reevaluate the merits of intervention in the Forex markets and the RBI has been restrained in its interventions ever since. Overall, the use of Monetary Policy in India has been constrained by a loose Fiscal Policy and Capital Flows. Capital Inflows have the potential to cause a Dutch Disease type situation and the Trade Balance and, more often than not, the Current Account continue to be in deficit. In what follows we will describe how these factors have interfered with the efficient functioning of Monetary Policy in India.
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RBI¶S MONETARY POLICIES AND ITS IMPACT MONETARY POLICY 2008-09
Despite the slowdown in growth, investment has remained relatively buoyant, growing at a rate higher than that of GDP. The ratio of fixed investment to GDP consequently increased to 32.2 per cent of GDP in 2008-09 from 31.6 per cent in 2007-08. This reflects the resilience of Indian enterprise, in the face of a massive increase in global uncertainty and risk aversion and freezing of highly developed financial markets. A noteworthy development during the year was a sharp rise in Wholesale Price Index (WPI) inflation followed by an equally sharp fall, with the WPI inflation falling to unprecedented level of close to zero per cent by March 2009. This was driven largely by the rapid rise and equally rapid fall in global commodity prices during January 2008 to March 2009. Domestic food price inflation, as measured by the WPI food sub-index, though declining, remains much higher than overall inflation. The global financial meltdown and consequent economic recession in developed economies have clearly been major factor in India¶s economic slowdown. Economic growth decelerated in 2008-09 to 6.7 per cent. This represented a decline of 2.1 per cent from the average growth rate of 8.8 per cent in the previous five years (2003-04 to 2007-08). Per capita GDP growth, a proxy for per capita income, which broadly reflects the improvement in the income of the average person, grew by an estimated 4.6 per cent in 2008-09. The growth of GDP at factor cost (at constant 1999-2000 prices) at 6.7 per cent in 200809 nevertheless represented a deceleration from high growth of 9.0 per cent and 9.7 per cent in 2007-08 and 2006-07 respectively The deceleration of growth in 2008-09 was spread across all sectors except mining and quarrying and community, social and personal services. The growth in agriculture and allied activities decelerated from 4.9 per cent in 2007-08 to 1.6 per cent in 200809. A notable feature of the growth of the Indian economy from 2002-03 has been the rising trend in the gross domestic capital formation (GDCF). Gross capital formation (GCF), which
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was 25.2 per cent of the GDP in 2002-03, increased to 39.1 per cent in 2007-08. Much of this increase is attributable to a rise in the rate of investment by the corporate sector. The growth in capital formation in recent years has been amply supported by a rise in the savings rate. The gross domestic savings as a percentage of GDP at current market prices stood at 37.7 per cent in 2007-08 as compared to 29.8 per cent in 2003-04. Private sector savings dominated the total savings in 2007-08 and were at 33.2 per cent of GDP. The saving investment gap in the public sector stood at (-) 5.3 per cent in 2003-04 that moderated to (-) 4.6 per cent in 2007-08. This reflected the narrowing gap between public sector capital formation and public sector gross domestic savings. For the household sector the gap has remained more or less constant reflecting no major change in the saving investment balance. In the case of the private corporate sector however, the saving investment gap widened to (-) 7.0 per cent in 2007-08 reflecting the high rate of capital formation over and above their internal savings. India could not insulate itself from the adverse developments in the international financial markets. The effect on the Indian economy was not significant in the beginning, but, the current account was affected mainly after September 2008 through slowdown in exports. Despite setbacks, however, the BOP situation of the country continues to remain resilient. The global crisis also meant that the economy experienced extreme volatility in terms of fluctuations in stock market prices, exchange rates and inflation levels during a short duration necessitating reversal of policy to deal with emergent situations. Before the onset of the financial crisis, the main concern of the policymakers was excessive capital inflows, which increased from 3.1 per cent of GDP in 2005-06 to 9.3 per cent in 2007-08. While this led to increase in foreign exchange reserves, it also contributed to monetary expansion, which fuelled liquidity growth. WPI inflation reached a trough of 3.1 per cent in October 2007, a month before global commodity price inflation zoomed to double digits from low single digits. The rising oil and commodity prices, contributed to a significant rise in prices, with annual WPI peaking at 12.8 per cent in August 2008. The monetary policy stance during the first half of 2008-09 was therefore directed at containing the price rise.
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The policy stance of the Reserve Bank of India (RBI) in the first half of the year was oriented towards controlling monetary expansion, in view of the apparent link between monetary expansion and inflationary expectations partly due to the perceived liquidity overhang. In the first six months of 2008-09, year-on-year growth of broad money was lower than the growth of reserve money. The Government also took various fiscal and administrative measures during the first half of 2008- 09 to rein in inflation. The key policy rates of RBI thus moved to signal a contractionary monetary stance. The repo rate (RR) was increased by 125 basis points in three tranches from 7.75 per cent at the beginning of April 2008 to 9.0 per cent with effect from August 30, 2008. The reverse-repo rate (R-RR) was however left unchanged at 6.0 per cent. The cash reserve ratio (CRR) was increased by 150 basis points in six tranches from 7.50 per cent at the beginning of April 2008 to 9.0 per cent with effect from August 30, 2008. The surge in the supply of foreign currency in the domestic market led inevitably to a rise in the price of the rupee. The rupee gradually appreciated from Rs. 46.54 per US dollar in August 2006 to Rs. 39.37 in January 2008, a movement that had begun to affect profitability and competitiveness of the export sector. The global financial crisis however reversed the rupee appreciation and after the end of positive shock around January 2008, rupee began a slow decline. The annual average exchange rate during 2008-09 worked out to Rs. 45.99 per US dollar compared to Rs. 40.26 per US dollar in 2007-08. The outflow of foreign exchange, as fallout of crisis, also meant tightening of liquidity situation in the economy. To deal with the liquidity crunch and the virtual freezing of international credit, the monetary stance underwent an abrupt change in the second half of 2008-09. The RBI responded to the emergent situation by facilitating monetary expansion through decreases in the CRR, repo and reverse repo rates, and the statutory liquidity ratio (SLR). The repo rate was reduced by 400 basis points in five tranches from 9.0 in August 2008 to 5.0 per cent beginning March 5, 2009. The reverse-repo rate was lowered by 250 basis points in three tranches from 6.0 (as was prevalent in November 2008) to 3.5 per cent from March 5, 2009. The reverse-repo and repo rates were again reduced by 25 basis points each with effect from April 21, 2009. SLR was lowered by 100 basis points from 25 per cent of net demand and time liabilities (NDTL) to 24 per cent with effect from the fortnight beginning November 8, 2008. The CRR was lowered by 400 basis points in four tranches from 9.0 to 5.0 per cent with 8
effect from January 17, 2009. The credit policy measures by the RBI broadly aimed at providing adequate liquidity to compensate for the squeeze emanating from foreign financial markets and improving foreign exchange liquidity. These measures were supplemented by sector - specific credit measures for exports, housing, micro and small enterprises and infrastructure. The monetary measures had a salutatory effect on the liquidity situation. The weighted average call money market rate, which had crossed the LAF corridor at several instances during the first half of 2008-09, remained within the LAF corridor after October 2008. Since mid-2008-09, the growth in reserve money decelerated after September 2008. The deceleration in M0 was largely on account of the decline in net foreign exchange assets (NFA) of RBI (a major determinant of reserve money growth) due to reduced capital inflows. On the other hand, the net domestic credit (NDC) of the RBI expanded due to an increase in net RBI credit to the Central Government in the second half of the year. Taking the year as whole, broad money (M3) recorded an increase of 18.4 per cent during 2008-09, as against 21.2 per cent in 2007-08. The money multiplier, which is the ratio of M3 to M0, was 4.3 in end-March 2008. The demand for bank credit increased sharply during April-October 2008 as companies found that external sources of credit were drying up in the wake of the global financial crisis. There was also a sharp increase in credit to oil marketing companies. However, towards the latter part of 2008-09, credit growth declined abruptly reflecting the slowdown of the economy in general and the industrial sector in particular. On a full year basis, bank credit growth fell from 22.3 per cent in 2007-08 to 17.3 per cent in 2008-09. Having regard to the structural rigidities associated with the money market, it was observed that the average PLR did not show much variation. From 12.5 per cent in April 2008, it increased to 13.9 per cent in September 2008 and thereafter declined to 12.0 per cent in March 2009. The overall balance of payments situation remained resilient in 2008-09 despite signs of strain in the capital and current accounts, due to the global crisis. The average WPI inflation for 2008-09 was 8.4 per cent as against 4.7 per cent in 2007-08. There has also been significant variation in 9
inflation rate in terms of WPI and the Consumer Price Indices (CPIs). Inflation rate as per Consumer Price Index for Rural Laborers (CPI-RL) was 9.7 per cent and on CPI for Industrial Workers (CPI-IW) was 8 per cent as of end-March 2009. The average inflation on CPI-RL and CPI-IW for the year 2008-09 was 10.2 and 9.1 per cent, respectively. The implicit deflator for GDPMP defined as the ratio of GDP at current prices to GDP at constant prices is the most comprehensive measure of inflation on an annual basis. Overall inflation, as measured by the aggregate deflator for GDPMP, declined from 5.0 per cent in 2006-07 to 4.9 per cent in 2007-08 and is estimated at 6.2 per cent in 2008-09 as a result of the higher inflation experienced during most of the year.
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MONETARY POLICY 2009-10
The fiscal year 2009-10 began as a difficult one. There was a significant slowdown in the growth rate in the second half of 2008-09, following the financial crisis that began in the industrialized nations in 2007 and spread to the real economy across the world. The growth rate of the gross domestic product (GDP) in 2008-09 was 6.7 per cent, with growth in the last two quarters hovering around 6 per cent. There was apprehension that this trend would persist for some time, as the full impact of the economic slowdown in the developed world worked through the system. It was also a year of reckoning for the policymakers, who had taken a calculated risk in providing substantial fiscal expansion to counter the negative fallout of the global slowdown. Inevitably, India¶s fiscal deficit increased from the end of 2007-08, reaching 6.8 per cent (budget estimate, BE) of GDP in 2009-10. A delayed and severely subnormal monsoon added to the overall uncertainty. The continued recession in the developed world, for the better part of 200910, meant a sluggish export recovery and a slowdown in financial flows into the economy. Yet, over the span of the year, the economy posted a remarkable recovery, not only in terms of overall growth figures but, more importantly, in terms of certain fundamentals, which justify optimism for the Indian economy in the medium to long term. The advance estimate of GDP growth at 7.2 per cent for 2009-10, falls within the range of 7 +/- 0.75 projected nearly a year ago in the Economic Survey 200809. With the downside risk to growth due to the delayed and sub-normal monsoons having been contained to a large extent, through the likelihood of a better-thanaverage Rabi agricultural season, the economy has responded well to the policy measures undertaken in the wake of the global financial crisis. While the GDP at factor costs at constant 2004-05 prices, is placed at Rs 44, 53, 064 crore, the GDP at market prices, at constant prices, is estimated at Rs 47, 67,142 crore. The corresponding figures at current prices are Rs 57, 91, 268 crore and Rs 61, 64, 178 crore respectively. It is worthwhile to note here that the growth rates of GDP at market prices, at constant 2004-05 prices, in 2008-09 and 2009-10 at 5.1 per cent and 6.8 per cent have 11
been considerably lower than the growth rates of GDP at factor cost. This is due to the significant decline in net indirect taxes (i.e. indirect taxes minus subsidies) in the said years on account of the fiscal stimulus implemented by the Government, which included tax relief to boost demand and increase in the expenditure on subsidies. The recovery in GDP growth for 2009-10, as indicated in the advance estimates, is broad based. Seven out of eight sectors/sub-sectors show a growth rate of 6.5 per cent or higher. The exception, as anticipated, is agriculture and allied sectors where the growth rate is estimated to be minus 0.2 per cent over 2008-09. Sectors including mining and quarrying; manufacturing; and electricity, gas and water supply have significantly improved their growth rates at over 8 per cent in comparison with 2008-09. The construction sector and trade, hotels, transport and communication have also improved their growth rates over the preceding year, though to a lesser extent. However, the growth rate of community, social and personal services has declined significantly, though it continues to be around its pre-global crisis medium-term trend growth rate.
Financing, insurance, real estate and business services have retained their growth momentum at around 10 per cent in 2009-10. In terms of sectored shares, the share of agriculture and allied sectors in GDP at factor cost has declined gradually from 18.9 per cent in 2004-05 to 14.6 per cent in 2009-10.
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During the same period, the share of industry has remained the same at about 28 per cent, while that of services has gone up from 53.2 per cent in 2004-05 to 57.2 per cent in 2009-10. The growth rates in per capita income and consumption, which are gross measures of welfare in general, have declined in the last two years. This is a reflection of the slowdown in the overall GDP growth. While the growth in per capita income, measured in terms of GDP at constant market prices, has declined from a high of 8.1 per cent in 2007-08 to 3.7 per cent in 2008-09 and then recovered to 5.3 per cent in 2009-10, per capita consumption growth as captured in the private final consumption expenditure (PFCE) shows a declining trend since 2007-08 with its growth rate in 2009-10 falling to one third of that in 2007-08. The rate of Gross domestic savings (GDS) on the new series increased from 32.2 per cent in 2004-05 to 36.4 per cent in 2007-08 before declining to 32.5 per cent in 2009-10. The year-on-year WPI inflation rate has been fairly volatile in 2009-10. It was 1.2 per cent in March 2009 and then declined continuously to become negative during June-August 2009, assisted in part by the large statistical base effect from the previous year. It turned positive in September 2009 and accelerated to 4.8 per cent in November 2009 and further to 7.3 per cent in December 2009. For the fiscal year so far (March over December 2009) WPI inflation is estimated at 8 per cent. The recent period has witnessed significant divergence in the WPI and CPI inflation rates, principally on account of the larger weights assigned to the food basket in the CPIs and due to the fact that retail prices are relatively sticky downwards. Thus, due to the sharp increase in essential commodity prices, while all the four CPIs remained elevated since March 2008, rising gradually from about 7 to 8 per cent (month-on-month) to around 15 to 17 per cent in December 2009, WPI inflation first went up from around 8 per cent to 13 per cent, then turned negative during June to August 2009 before rising again to over 7 per cent in December 2009. As measured by the aggregate deflator for GDPMP, inflation has been estimated at 3.6 per cent in 2009-10 as per the advance estimates. Consumer inflation, as measured by the deflator for the PFCE, is estimated at 6.4 per cent in 2009-10, as per the advance estimates. The global economy, led by the Asian economies especially China and India, has shown signs of recovery in fiscal 2009-10. While global trade is gradually picking up, the other indicators of 13
economic activity such as capital flows, assets and commodity prices are more buoyant. However, there has been improvement in the balance of payments situation during 2009-10 over 2008-09, reflecting higher net capital inflows and lower trade deficit. Since the outbreak of the global financial crisis in September 2008, the RBI has followed an accommodative monetary policy. In the course of 2009-10, this stance was principally geared towards supporting early recovery of the growth momentum, while facilitating the unprecedented borrowing requirement of the Government to fund its fiscal deficit. The fact that the latter was managed well with nearly two-thirds of the borrowing being completed in the first half of the fiscal year not only helped in checking undue pressure on interest rates, but also created the space for the revival of private investment demand in the second half of the year. The transmission of monetary policy measures continues to be sluggish and differential in its impact across various segments of the financial markets. The downward revisions in policy rates announced by the RBI post-September 2008 got transmitted into the money and G-Sec markets; however, the transmission has been slow and lagged in the case of the credit market. Though lending rates of all categories of banks (public, private and foreign) declined marginally from March 2009 (with benchmark prime lending rates [BPLR] of scheduled commercial banks [SCBs] having declined by 25 to 100 basis points), the decline was not sufficient to accelerate the demand for bank credit. Consequently, while borrowers have turned to alternate sources of possibly cheaper finance to meet their funding needs, banks flush with liquidity parked their surplus funds under the reverse repo window. There has been continuous moderation in the growth in broad money (M3) from around 21 per cent at the beginning of the fiscal year to 16.5 per cent as of mid-January 2010 and it has remained below the indicated growth projection for the period. While in the first half of the year, credit to the Government remained the key driver of money growth, since the third quarter of 2009-10 that too has moderated. Demand for bank credit/non-food credit remained muted during 2009-10. It was only from November 2009 that some signs of pick-up became evident. On financial-year basis, growth in non-food credit remained negative till June 2009. It is also noteworthy that growth in 14
aggregate deposits has remained higher than the growth in bank credit during 2009-10. The lower expansion in credit relative to the significant expansion in deposits during 2009-10 has resulted in a decline in the credit-deposit ratio from 72.4 in end March 2009 to 70.8 in midJanuary 2010, though with some signs of revival since December 2009. Growth in sectored deployment of gross bank credit on a year-on-year basis (as on November 20, 2009) shows that retail credit has not picked up during 2009-10. While growth in credit to agriculture remained more or less the same as on the corresponding date of the preceding year, for the other broad sectors±industry, personal loans and services²growth in credit decelerated as compared to the corresponding period of the preceding year. The contribution of non-bank credit sources increased from 52 per cent in 2008-09 to nearly 61 per cent in 2009-10. This increase in flow of funds from non-banking sources was both from domestic and foreign sources and is indicative of structural rigidities that affect the monetary transmission mechanism particularly in respect of the credit markets. A major concern was regarding the possibility of a rise in unemployment due to the slowdown of the economy. On the whole, for the period October 2008 to September 2009, there may have been a net addition of 1.51 lakh jobs in the different sectors. Under the NREGA, which is a major rural employment initiative, during the year 2009-10, 4.34 crore households have been provided employment so far.
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MONETARY POLICY 2010-11
GDP growth during 2010-11 reverted to the high growth trajectory. Growth had moderated in the preceding two years as the global economy slowed down as a result of global financial crisis. The growth during 2010-11 reflects a rebound in agriculture and sustained levels of activity in industry and services. Overall growth indicators are mixed. Prospects for agriculture appear encouraging, given IMD¶s forecast of a normal monsoon and a good outturn of Rabi in 2010-11. Industrial growth, however, moderated in the second half largely reflecting the waning of base effects and contraction in capital goods output. The deceleration has, however, been exacerbated by few items with volatile output. Other indicators, such as the Purchasing Managers¶ Index (PMI), direct and indirect tax collections, merchandise exports and bank credit suggest that the growth momentum persists. Indicators on services sector activity also remain robust, notwithstanding some deceleration in the government-spending related services. However, high energy and commodity prices may impact output and investment climate, and pose a threat to maintaining high growth at a time when the investment momentum may be slowing down. Aggregate demand accelerated further in 2010-11 even as rebalancing took place from government consumption spending to private consumption and investment. Momentum in overall demand conditions was reflected in indicators like corporate sales growth, improving capacity utilization, higher employment and pricing power with the producers. However, aggregate investment moderated somewhat in Q3 of 2010-11. This slackening was also reflected in the contraction in capital goods output and weaker new project investment indicated by banks. This process needs to be reversed to bolster the potential growth of the economy. The Monetary Policy for 2010-11 is set against a rather complex economic backdrop. Although the situation is more reassuring than it was a quarter ago, uncertainty about the shape and pace of global recovery persists. Private spending in advanced economies continues to be constrained and inflation remains generally subdued making it likely that fiscal and monetary stimuli in these economies will continue for an extended period. Emerging market economies (EMEs) are significantly ahead on the recovery curve, but some of them are also facing inflationary pressures. Broad money supply (M3) growth at 15.9 per cent (year-on-year) during 2010-11 was lower than the Reserve Bank¶s indicative trajectory of 17 per cent due to slow
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deposit growth and acceleration in currency growth. The higher currency demand slowed the money multiplier. Consequently, M3 growth slowed despite a significant increase in reserve money. This suggests that money supply growth was not a contributing factor to inflation. The monetary policy stance in 2010-11 was calibrated on the basis of the domestic growth-inflation dynamics amidst persistent global uncertainties. he 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 normalising 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 corporates has returned. With the growth expected to accelerate further in the next year, capacity constraints will reemerge, 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
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liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government borrowing programme is not hampered. On the basis of the current assessment and in line with the policy stance, the Reserve Bank implemented the following policy measures: Bank Rate y The Bank Rate has been retained at 6.0 per cent.
Repo Rate
y
Increased the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.0 per cent to 5.25 per cent.
Reverse Repo Rate
y
Increased the reverse repo rate under the LAF by 25 basis points from 3.5 per cent to 3.75 per cent.
Cash Reserve Ratio
y
Increased 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).
The result of the increase in the CRR is that about Rs. 12,500 crore of excess liquidity will be absorbed from the system By implanting these changes, the RBI was able to curb the inflation which is soaring and the growth rate can be sustained at the current level. Real GDP growth in 2010-11 reverted to near trend growth rate, following two successive years of below trend growth. Nonagricultural GDP growth, however,
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was slightly below the trend. The main impetus to the growth in 2010-11 came from agriculture which benefited from a normal monsoon, while industry and services registered mild deceleration. This moderation was primarily during the second half of the year due to the waning of the favorable base effect as well as deceleration in Government-spending related services. Growth is expected to stay near its trend during 2011-12 with upside factors such as buoyant private consumption demand and improved external demand getting counterbalanced by likely adverse impact from high fuel and commodity prices and prevailing risks to global growth from the debt crisis in parts of the Euro zone. Industrial growth decelerates on account of high base effect and moderation in investment demand. During 2010-11, the industrial sector exhibited signs of slowdown as the IIP growth moderated with intermittent episodes of volatility mainly on account of the high base effect and sharp deceleration in capital and intermediate goods which could partly be attributed to the moderation in investment demand in Q3 of 2010-11. The lower growth in IIP during AprilFebruary 2010-11 compared to the corresponding period of the previous year has been on account of the slowdown in growth of almost all the sectors except consumer goods. The contribution of intermediate and capital goods to the overall IIP growth declined, reflecting some moderation in investment demand. The continued high growth of consumer reflects consumption durables higher demand. segment private Amidst
slowdown, manufacturing activity spread more evenly. One notable feature of the pattern of IIP growth is that the activity in manufacturing sector has become more evenly spread with fifteen out of seventeen industries recording positive growth during April-February 2010-11. Moreover, the contribution of the bottom twelve industries to the
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overall IIP growth has increased. The recent IIP slowdown during the period November 2010 to February 2011 has been exacerbated by a few industries. If IIP growth is calculated after excluding the top 10 and the bottom 10 items that tend to disproportionately impact the overall IIP on account of wide volatility, the growth in February 2011 would be close to 8.8 per cent visà-vis 8.7 per cent in January 2011 and 11.2 per cent in February 2010. This suggests that the deceleration is not as pronounced as it may appear from the headline numbers. Nevertheless, the risk to industrial growth remains with deceleration in output of capital goods
During the period April 2010 to March 2011 RBI increased the Reverse Repo rate from 3.75 to 5.75 and the Repo Rate from 5.25 to 6.75 in order to curb the inflation. But this rate hike brought the investment in industries down but due to the high demand for automobiles and constructions the manufacturing segment was able to make an improvement. There have been significant changes in the drivers of inflation during 2010-11. First, while there are some signs of seasonal moderation in food prices, overall food inflation continues at an elevated level. It is likely that structural shortage of certain agricultural commodities such as pulses, edible oils and milk could reduce the pace of food price moderation. Second, the firming up of global commodity prices poses upside risks to inflation. Third, the Reserve Bank¶s industrial outlook survey shows that corporates are increasingly regaining their pricing power in many sectors. As the recovery gains further momentum, the demand pressures are expected to accentuate. Fourth, the Reserve Bank¶s quarterly inflation expectations survey for households indicates that household inflation expectations have remained at an elevated level
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The expected outcomes of the RBI¶s monetary policy were: (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. The key rate changes during the period 2010-11 can be referred from the table below
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Bibliography
http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=6376 http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=5602 http://stockthoughts.wordpress.com/2008/04/05/what-is-cash-reserve-ratio-and-howwill-the-crr-hike-impact-you/ http://www.banknetindia.com/ Baumol,Blinder et al (2009) Macroeconomics. Third Indian Reprint 2011, Nelson Education , Ltd. (CENGAGE Leanring)
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doc_798180982.docx
RBI's Monetary policies from 2008-2011
IMPACT OF RBI'S MONETARY POLICIES ON OVERALL ECONOMIC GROWTH, INDUSTRIAL PRODUCTION DURING 2008-11
Submitted By Rahul S Roll No : 11DM116 Section B, PGDM
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ACKNOWLEGEMENT
We would like to show our greatest appreciation to our Prof. Jagdish Shettigar. We can¶t thank him enough for his tremendous support and help throughout the period of making of this report. Without his encouragement and guidance this project would not have materialized.
The research and study done during the preparation of this report helped us to have an insight about the monetary policies of RBI and their impact on inflation.
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CONTENTS
1.
Introduction ........................................................................................ 1
2. Monetary Policy .................................................................................. 2 3. Impact of Monetary Policy on Economic Growth ............................ 3 4. Impact of Monetary Policy on Industrial Growth ............................ 5 5. Monetary policy 2008-09 .................................................................... 6 6. Monetary policy 2009-10 .................................................................. 11 7. Monetary policy 2010-11 .................................................................. 16 8. Bibliography ..................................................................................... 22
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INTRODUCTION
By monetary policy, we mean policy concerned with changes in the supply of money. Issues connected with monetary policy are: objectives or goals of the policy, instruments of monetary control, its efficacy, implementation, intermediate target of the policy etc. India¶s monetary policy since the first plan period was one of 'controlled expansion¶- that is, a policy of adequate financing of economic growth ensuring reasonable price stability. Thus, RBI helped the economy to expand via expansion of money and credit and attempted to check rise in prices through monetary and other control measures. A mild version of the liberalization process in the Indian economy was initiated in the mid 1980s. But, it lacked depth, coverage and self sustaining character. During the far end of the 1980¶s the economy suffered a big jolt with the eruption of a major macro-economic crisis. It manifested initially in the form of foreign exchange crisis, and then debt and interest payment problems. To meet the crisis India approached the World Bank and the International Monetary Fund (IMF) for a big loan. For granting the loan, World Bank and the IMF stipulated certain conditions. Since India was in a critical situation, she accepted the conditions of the World Bank and the IMF and then provided an immediate context for the realignment of the macro-economic fundamentals, through a programme of economic stabilization. With this end in view, India initiated the new economic policy in July 1991. The package of economic reforms, which are expected to have long-term impact on the economy, includes fiscal, monetary, financial, and industrial and export-import (EXIM) sector reforms. The reforms in monetary and credit policies aimed at slowing down monetary expansion and thereby controlling inflation. The financial sector reforms were initiated on the recommendations of Narasimham Committee Report. The first phase of reform started with a reduction of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) and permitted a degree of flexibility to the banks in the matter of deposit interest rates. Money markets facilitate the conduct of monetary policy in a country. The development of money market in India in the last few years has been facilitated by some major factors. Firstly, it permitted a gradual de-emphasis on cash reserve ratio as a monetary policy instrument.
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Secondly, the development of an array of instruments of indirect monetary control, such as, the Bank Rate and the Liquidity Adjustment Facility (LAF). Thirdly, monetary policy is often, shaped by developments in the money and the foreign exchange markets. MONETARY POLICY: Monetary policy is the process by which the government, central bank, or monetary authority of a country controls y y y The supply of money Availability of money Cost of money or interest rates
to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate to achieve policy goals. A monetary policy can be either Expansionary or Contractionary. It is referred to as Expansionary if it increases the supply of money in the economy by decreasing the interest rates. It is referred to as Contractionary if it lowers the supply of money in the economy by increasing the interest rates. The primary tool of monetary Policy is Open Market Operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.
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It is the Central bank that influences interest rates by expanding or contracting the monetary base by way of open market operations. IMPACT OF MONETARY POLICY ON ECONOMIC GROWTH: There are two different views on what effect a Monetary policy can have on the country¶s GDP. Monetarists¶ view: It argues that the demand for money is stable and is not very sensitive to changes in the rate of interest. Hence, expansionary monetary policies only serve to create a surplus of money that households will quickly spend, thereby increasing aggregate demand. Unlike classical economists, monetarists acknowledge that the economy may not always be operating at the full employment level of real GDP. Thus, in the short-run, monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand. However, in the long-run, when the economy is operating at the full employment level, monetarists argue that the classical quantity theory remains a good approximation of the link between the supply of money, the price level, and the real GDP. According to this theory, an increase (decrease) in the quantity of money leads to a proportional increase (decrease) in the price level. The quantity theory of money is usually discussed in terms of the equation of exchange, which is given by the expression MV=PY Where M: money supply V: Velocity of money P: Price level Y: Level of current GDP Classical economists assume that Y in the equation of exchange is fixed, at least in the short-run. Furthermore, classical economists argue that the velocity of circulation of money tends 3
to remain constant so that V can also be regarded as fixed. Assuming that both Y and V are fixed, it follows that in case of expansionary (or contractionary) monetary policy, leading to an increase (or decrease) in M, would only lead to an increase (or decrease) the price level, P, in direct proportion to the change in M. Thus, in the long-run, monetary policies only lead to inflation or deflation and do not affect the level of real GDP. Keynesian view: does not believe in the direct link between the supply of money and the price level that emerges from the classical quantity theory of money. They reject the notion that the economy is always at or near the natural level of real GDP so that Y in the equation of exchange can be regarded as fixed. They also reject the proposition that the velocity of circulation of money is constant. Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system, causing interest rates to fall. With lower interest rates, aggregate expenditures on investment and interest-sensitive consumption goods usually increase, causing real GDP to rise. Hence, monetary policy can affect real GDP indirectly. IMPACT OF MONETARY POLICY ON INDSUTRIAL PRODUCTION: Monetary policy affects Industrial production through its effect on interest rates which determines the cost of borrowing for investors. For ex., the influencing of the interest rate by the Central Bank through announcing targets for benchmark interest rates determines the cost of funds for financial institutions and hence the rates at which they are willing to lend. Higher interest rates lower the net rates of return for investment projects and projects with lower gross rates of return are not initiated. Similarly, expansionary monetary policy lowers the cost of borrowing via lower interest rates and allows projects with lower rates of return to be profitable. RBI¶S APPROACH TO MONETARY POLICY: The RBI conducts Monetary Policy by announcing targets for its benchmark lending rates wiz. repo & reverse repo rates and the bank rate. It then intervenes in the Bond Market to achieve the announced rates. The RBI¶s Monetary Policy from 2008-2011 must be understood in the backdrop of the massive sterilized interventions in the currency market that the RBI undertook 4
2003 onwards which has led to a massive accumulation of µMarket Stabilization Scheme¶ bonds, the servicing of which has led to a direct expansion of the RBI¶s Balance Sheet. The sheer accumulated volume of these bonds has led the RBI to reevaluate the merits of intervention in the Forex markets and the RBI has been restrained in its interventions ever since. Overall, the use of Monetary Policy in India has been constrained by a loose Fiscal Policy and Capital Flows. Capital Inflows have the potential to cause a Dutch Disease type situation and the Trade Balance and, more often than not, the Current Account continue to be in deficit. In what follows we will describe how these factors have interfered with the efficient functioning of Monetary Policy in India.
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RBI¶S MONETARY POLICIES AND ITS IMPACT MONETARY POLICY 2008-09
Despite the slowdown in growth, investment has remained relatively buoyant, growing at a rate higher than that of GDP. The ratio of fixed investment to GDP consequently increased to 32.2 per cent of GDP in 2008-09 from 31.6 per cent in 2007-08. This reflects the resilience of Indian enterprise, in the face of a massive increase in global uncertainty and risk aversion and freezing of highly developed financial markets. A noteworthy development during the year was a sharp rise in Wholesale Price Index (WPI) inflation followed by an equally sharp fall, with the WPI inflation falling to unprecedented level of close to zero per cent by March 2009. This was driven largely by the rapid rise and equally rapid fall in global commodity prices during January 2008 to March 2009. Domestic food price inflation, as measured by the WPI food sub-index, though declining, remains much higher than overall inflation. The global financial meltdown and consequent economic recession in developed economies have clearly been major factor in India¶s economic slowdown. Economic growth decelerated in 2008-09 to 6.7 per cent. This represented a decline of 2.1 per cent from the average growth rate of 8.8 per cent in the previous five years (2003-04 to 2007-08). Per capita GDP growth, a proxy for per capita income, which broadly reflects the improvement in the income of the average person, grew by an estimated 4.6 per cent in 2008-09. The growth of GDP at factor cost (at constant 1999-2000 prices) at 6.7 per cent in 200809 nevertheless represented a deceleration from high growth of 9.0 per cent and 9.7 per cent in 2007-08 and 2006-07 respectively The deceleration of growth in 2008-09 was spread across all sectors except mining and quarrying and community, social and personal services. The growth in agriculture and allied activities decelerated from 4.9 per cent in 2007-08 to 1.6 per cent in 200809. A notable feature of the growth of the Indian economy from 2002-03 has been the rising trend in the gross domestic capital formation (GDCF). Gross capital formation (GCF), which
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was 25.2 per cent of the GDP in 2002-03, increased to 39.1 per cent in 2007-08. Much of this increase is attributable to a rise in the rate of investment by the corporate sector. The growth in capital formation in recent years has been amply supported by a rise in the savings rate. The gross domestic savings as a percentage of GDP at current market prices stood at 37.7 per cent in 2007-08 as compared to 29.8 per cent in 2003-04. Private sector savings dominated the total savings in 2007-08 and were at 33.2 per cent of GDP. The saving investment gap in the public sector stood at (-) 5.3 per cent in 2003-04 that moderated to (-) 4.6 per cent in 2007-08. This reflected the narrowing gap between public sector capital formation and public sector gross domestic savings. For the household sector the gap has remained more or less constant reflecting no major change in the saving investment balance. In the case of the private corporate sector however, the saving investment gap widened to (-) 7.0 per cent in 2007-08 reflecting the high rate of capital formation over and above their internal savings. India could not insulate itself from the adverse developments in the international financial markets. The effect on the Indian economy was not significant in the beginning, but, the current account was affected mainly after September 2008 through slowdown in exports. Despite setbacks, however, the BOP situation of the country continues to remain resilient. The global crisis also meant that the economy experienced extreme volatility in terms of fluctuations in stock market prices, exchange rates and inflation levels during a short duration necessitating reversal of policy to deal with emergent situations. Before the onset of the financial crisis, the main concern of the policymakers was excessive capital inflows, which increased from 3.1 per cent of GDP in 2005-06 to 9.3 per cent in 2007-08. While this led to increase in foreign exchange reserves, it also contributed to monetary expansion, which fuelled liquidity growth. WPI inflation reached a trough of 3.1 per cent in October 2007, a month before global commodity price inflation zoomed to double digits from low single digits. The rising oil and commodity prices, contributed to a significant rise in prices, with annual WPI peaking at 12.8 per cent in August 2008. The monetary policy stance during the first half of 2008-09 was therefore directed at containing the price rise.
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The policy stance of the Reserve Bank of India (RBI) in the first half of the year was oriented towards controlling monetary expansion, in view of the apparent link between monetary expansion and inflationary expectations partly due to the perceived liquidity overhang. In the first six months of 2008-09, year-on-year growth of broad money was lower than the growth of reserve money. The Government also took various fiscal and administrative measures during the first half of 2008- 09 to rein in inflation. The key policy rates of RBI thus moved to signal a contractionary monetary stance. The repo rate (RR) was increased by 125 basis points in three tranches from 7.75 per cent at the beginning of April 2008 to 9.0 per cent with effect from August 30, 2008. The reverse-repo rate (R-RR) was however left unchanged at 6.0 per cent. The cash reserve ratio (CRR) was increased by 150 basis points in six tranches from 7.50 per cent at the beginning of April 2008 to 9.0 per cent with effect from August 30, 2008. The surge in the supply of foreign currency in the domestic market led inevitably to a rise in the price of the rupee. The rupee gradually appreciated from Rs. 46.54 per US dollar in August 2006 to Rs. 39.37 in January 2008, a movement that had begun to affect profitability and competitiveness of the export sector. The global financial crisis however reversed the rupee appreciation and after the end of positive shock around January 2008, rupee began a slow decline. The annual average exchange rate during 2008-09 worked out to Rs. 45.99 per US dollar compared to Rs. 40.26 per US dollar in 2007-08. The outflow of foreign exchange, as fallout of crisis, also meant tightening of liquidity situation in the economy. To deal with the liquidity crunch and the virtual freezing of international credit, the monetary stance underwent an abrupt change in the second half of 2008-09. The RBI responded to the emergent situation by facilitating monetary expansion through decreases in the CRR, repo and reverse repo rates, and the statutory liquidity ratio (SLR). The repo rate was reduced by 400 basis points in five tranches from 9.0 in August 2008 to 5.0 per cent beginning March 5, 2009. The reverse-repo rate was lowered by 250 basis points in three tranches from 6.0 (as was prevalent in November 2008) to 3.5 per cent from March 5, 2009. The reverse-repo and repo rates were again reduced by 25 basis points each with effect from April 21, 2009. SLR was lowered by 100 basis points from 25 per cent of net demand and time liabilities (NDTL) to 24 per cent with effect from the fortnight beginning November 8, 2008. The CRR was lowered by 400 basis points in four tranches from 9.0 to 5.0 per cent with 8
effect from January 17, 2009. The credit policy measures by the RBI broadly aimed at providing adequate liquidity to compensate for the squeeze emanating from foreign financial markets and improving foreign exchange liquidity. These measures were supplemented by sector - specific credit measures for exports, housing, micro and small enterprises and infrastructure. The monetary measures had a salutatory effect on the liquidity situation. The weighted average call money market rate, which had crossed the LAF corridor at several instances during the first half of 2008-09, remained within the LAF corridor after October 2008. Since mid-2008-09, the growth in reserve money decelerated after September 2008. The deceleration in M0 was largely on account of the decline in net foreign exchange assets (NFA) of RBI (a major determinant of reserve money growth) due to reduced capital inflows. On the other hand, the net domestic credit (NDC) of the RBI expanded due to an increase in net RBI credit to the Central Government in the second half of the year. Taking the year as whole, broad money (M3) recorded an increase of 18.4 per cent during 2008-09, as against 21.2 per cent in 2007-08. The money multiplier, which is the ratio of M3 to M0, was 4.3 in end-March 2008. The demand for bank credit increased sharply during April-October 2008 as companies found that external sources of credit were drying up in the wake of the global financial crisis. There was also a sharp increase in credit to oil marketing companies. However, towards the latter part of 2008-09, credit growth declined abruptly reflecting the slowdown of the economy in general and the industrial sector in particular. On a full year basis, bank credit growth fell from 22.3 per cent in 2007-08 to 17.3 per cent in 2008-09. Having regard to the structural rigidities associated with the money market, it was observed that the average PLR did not show much variation. From 12.5 per cent in April 2008, it increased to 13.9 per cent in September 2008 and thereafter declined to 12.0 per cent in March 2009. The overall balance of payments situation remained resilient in 2008-09 despite signs of strain in the capital and current accounts, due to the global crisis. The average WPI inflation for 2008-09 was 8.4 per cent as against 4.7 per cent in 2007-08. There has also been significant variation in 9
inflation rate in terms of WPI and the Consumer Price Indices (CPIs). Inflation rate as per Consumer Price Index for Rural Laborers (CPI-RL) was 9.7 per cent and on CPI for Industrial Workers (CPI-IW) was 8 per cent as of end-March 2009. The average inflation on CPI-RL and CPI-IW for the year 2008-09 was 10.2 and 9.1 per cent, respectively. The implicit deflator for GDPMP defined as the ratio of GDP at current prices to GDP at constant prices is the most comprehensive measure of inflation on an annual basis. Overall inflation, as measured by the aggregate deflator for GDPMP, declined from 5.0 per cent in 2006-07 to 4.9 per cent in 2007-08 and is estimated at 6.2 per cent in 2008-09 as a result of the higher inflation experienced during most of the year.
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MONETARY POLICY 2009-10
The fiscal year 2009-10 began as a difficult one. There was a significant slowdown in the growth rate in the second half of 2008-09, following the financial crisis that began in the industrialized nations in 2007 and spread to the real economy across the world. The growth rate of the gross domestic product (GDP) in 2008-09 was 6.7 per cent, with growth in the last two quarters hovering around 6 per cent. There was apprehension that this trend would persist for some time, as the full impact of the economic slowdown in the developed world worked through the system. It was also a year of reckoning for the policymakers, who had taken a calculated risk in providing substantial fiscal expansion to counter the negative fallout of the global slowdown. Inevitably, India¶s fiscal deficit increased from the end of 2007-08, reaching 6.8 per cent (budget estimate, BE) of GDP in 2009-10. A delayed and severely subnormal monsoon added to the overall uncertainty. The continued recession in the developed world, for the better part of 200910, meant a sluggish export recovery and a slowdown in financial flows into the economy. Yet, over the span of the year, the economy posted a remarkable recovery, not only in terms of overall growth figures but, more importantly, in terms of certain fundamentals, which justify optimism for the Indian economy in the medium to long term. The advance estimate of GDP growth at 7.2 per cent for 2009-10, falls within the range of 7 +/- 0.75 projected nearly a year ago in the Economic Survey 200809. With the downside risk to growth due to the delayed and sub-normal monsoons having been contained to a large extent, through the likelihood of a better-thanaverage Rabi agricultural season, the economy has responded well to the policy measures undertaken in the wake of the global financial crisis. While the GDP at factor costs at constant 2004-05 prices, is placed at Rs 44, 53, 064 crore, the GDP at market prices, at constant prices, is estimated at Rs 47, 67,142 crore. The corresponding figures at current prices are Rs 57, 91, 268 crore and Rs 61, 64, 178 crore respectively. It is worthwhile to note here that the growth rates of GDP at market prices, at constant 2004-05 prices, in 2008-09 and 2009-10 at 5.1 per cent and 6.8 per cent have 11
been considerably lower than the growth rates of GDP at factor cost. This is due to the significant decline in net indirect taxes (i.e. indirect taxes minus subsidies) in the said years on account of the fiscal stimulus implemented by the Government, which included tax relief to boost demand and increase in the expenditure on subsidies. The recovery in GDP growth for 2009-10, as indicated in the advance estimates, is broad based. Seven out of eight sectors/sub-sectors show a growth rate of 6.5 per cent or higher. The exception, as anticipated, is agriculture and allied sectors where the growth rate is estimated to be minus 0.2 per cent over 2008-09. Sectors including mining and quarrying; manufacturing; and electricity, gas and water supply have significantly improved their growth rates at over 8 per cent in comparison with 2008-09. The construction sector and trade, hotels, transport and communication have also improved their growth rates over the preceding year, though to a lesser extent. However, the growth rate of community, social and personal services has declined significantly, though it continues to be around its pre-global crisis medium-term trend growth rate.
Financing, insurance, real estate and business services have retained their growth momentum at around 10 per cent in 2009-10. In terms of sectored shares, the share of agriculture and allied sectors in GDP at factor cost has declined gradually from 18.9 per cent in 2004-05 to 14.6 per cent in 2009-10.
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During the same period, the share of industry has remained the same at about 28 per cent, while that of services has gone up from 53.2 per cent in 2004-05 to 57.2 per cent in 2009-10. The growth rates in per capita income and consumption, which are gross measures of welfare in general, have declined in the last two years. This is a reflection of the slowdown in the overall GDP growth. While the growth in per capita income, measured in terms of GDP at constant market prices, has declined from a high of 8.1 per cent in 2007-08 to 3.7 per cent in 2008-09 and then recovered to 5.3 per cent in 2009-10, per capita consumption growth as captured in the private final consumption expenditure (PFCE) shows a declining trend since 2007-08 with its growth rate in 2009-10 falling to one third of that in 2007-08. The rate of Gross domestic savings (GDS) on the new series increased from 32.2 per cent in 2004-05 to 36.4 per cent in 2007-08 before declining to 32.5 per cent in 2009-10. The year-on-year WPI inflation rate has been fairly volatile in 2009-10. It was 1.2 per cent in March 2009 and then declined continuously to become negative during June-August 2009, assisted in part by the large statistical base effect from the previous year. It turned positive in September 2009 and accelerated to 4.8 per cent in November 2009 and further to 7.3 per cent in December 2009. For the fiscal year so far (March over December 2009) WPI inflation is estimated at 8 per cent. The recent period has witnessed significant divergence in the WPI and CPI inflation rates, principally on account of the larger weights assigned to the food basket in the CPIs and due to the fact that retail prices are relatively sticky downwards. Thus, due to the sharp increase in essential commodity prices, while all the four CPIs remained elevated since March 2008, rising gradually from about 7 to 8 per cent (month-on-month) to around 15 to 17 per cent in December 2009, WPI inflation first went up from around 8 per cent to 13 per cent, then turned negative during June to August 2009 before rising again to over 7 per cent in December 2009. As measured by the aggregate deflator for GDPMP, inflation has been estimated at 3.6 per cent in 2009-10 as per the advance estimates. Consumer inflation, as measured by the deflator for the PFCE, is estimated at 6.4 per cent in 2009-10, as per the advance estimates. The global economy, led by the Asian economies especially China and India, has shown signs of recovery in fiscal 2009-10. While global trade is gradually picking up, the other indicators of 13
economic activity such as capital flows, assets and commodity prices are more buoyant. However, there has been improvement in the balance of payments situation during 2009-10 over 2008-09, reflecting higher net capital inflows and lower trade deficit. Since the outbreak of the global financial crisis in September 2008, the RBI has followed an accommodative monetary policy. In the course of 2009-10, this stance was principally geared towards supporting early recovery of the growth momentum, while facilitating the unprecedented borrowing requirement of the Government to fund its fiscal deficit. The fact that the latter was managed well with nearly two-thirds of the borrowing being completed in the first half of the fiscal year not only helped in checking undue pressure on interest rates, but also created the space for the revival of private investment demand in the second half of the year. The transmission of monetary policy measures continues to be sluggish and differential in its impact across various segments of the financial markets. The downward revisions in policy rates announced by the RBI post-September 2008 got transmitted into the money and G-Sec markets; however, the transmission has been slow and lagged in the case of the credit market. Though lending rates of all categories of banks (public, private and foreign) declined marginally from March 2009 (with benchmark prime lending rates [BPLR] of scheduled commercial banks [SCBs] having declined by 25 to 100 basis points), the decline was not sufficient to accelerate the demand for bank credit. Consequently, while borrowers have turned to alternate sources of possibly cheaper finance to meet their funding needs, banks flush with liquidity parked their surplus funds under the reverse repo window. There has been continuous moderation in the growth in broad money (M3) from around 21 per cent at the beginning of the fiscal year to 16.5 per cent as of mid-January 2010 and it has remained below the indicated growth projection for the period. While in the first half of the year, credit to the Government remained the key driver of money growth, since the third quarter of 2009-10 that too has moderated. Demand for bank credit/non-food credit remained muted during 2009-10. It was only from November 2009 that some signs of pick-up became evident. On financial-year basis, growth in non-food credit remained negative till June 2009. It is also noteworthy that growth in 14
aggregate deposits has remained higher than the growth in bank credit during 2009-10. The lower expansion in credit relative to the significant expansion in deposits during 2009-10 has resulted in a decline in the credit-deposit ratio from 72.4 in end March 2009 to 70.8 in midJanuary 2010, though with some signs of revival since December 2009. Growth in sectored deployment of gross bank credit on a year-on-year basis (as on November 20, 2009) shows that retail credit has not picked up during 2009-10. While growth in credit to agriculture remained more or less the same as on the corresponding date of the preceding year, for the other broad sectors±industry, personal loans and services²growth in credit decelerated as compared to the corresponding period of the preceding year. The contribution of non-bank credit sources increased from 52 per cent in 2008-09 to nearly 61 per cent in 2009-10. This increase in flow of funds from non-banking sources was both from domestic and foreign sources and is indicative of structural rigidities that affect the monetary transmission mechanism particularly in respect of the credit markets. A major concern was regarding the possibility of a rise in unemployment due to the slowdown of the economy. On the whole, for the period October 2008 to September 2009, there may have been a net addition of 1.51 lakh jobs in the different sectors. Under the NREGA, which is a major rural employment initiative, during the year 2009-10, 4.34 crore households have been provided employment so far.
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MONETARY POLICY 2010-11
GDP growth during 2010-11 reverted to the high growth trajectory. Growth had moderated in the preceding two years as the global economy slowed down as a result of global financial crisis. The growth during 2010-11 reflects a rebound in agriculture and sustained levels of activity in industry and services. Overall growth indicators are mixed. Prospects for agriculture appear encouraging, given IMD¶s forecast of a normal monsoon and a good outturn of Rabi in 2010-11. Industrial growth, however, moderated in the second half largely reflecting the waning of base effects and contraction in capital goods output. The deceleration has, however, been exacerbated by few items with volatile output. Other indicators, such as the Purchasing Managers¶ Index (PMI), direct and indirect tax collections, merchandise exports and bank credit suggest that the growth momentum persists. Indicators on services sector activity also remain robust, notwithstanding some deceleration in the government-spending related services. However, high energy and commodity prices may impact output and investment climate, and pose a threat to maintaining high growth at a time when the investment momentum may be slowing down. Aggregate demand accelerated further in 2010-11 even as rebalancing took place from government consumption spending to private consumption and investment. Momentum in overall demand conditions was reflected in indicators like corporate sales growth, improving capacity utilization, higher employment and pricing power with the producers. However, aggregate investment moderated somewhat in Q3 of 2010-11. This slackening was also reflected in the contraction in capital goods output and weaker new project investment indicated by banks. This process needs to be reversed to bolster the potential growth of the economy. The Monetary Policy for 2010-11 is set against a rather complex economic backdrop. Although the situation is more reassuring than it was a quarter ago, uncertainty about the shape and pace of global recovery persists. Private spending in advanced economies continues to be constrained and inflation remains generally subdued making it likely that fiscal and monetary stimuli in these economies will continue for an extended period. Emerging market economies (EMEs) are significantly ahead on the recovery curve, but some of them are also facing inflationary pressures. Broad money supply (M3) growth at 15.9 per cent (year-on-year) during 2010-11 was lower than the Reserve Bank¶s indicative trajectory of 17 per cent due to slow
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deposit growth and acceleration in currency growth. The higher currency demand slowed the money multiplier. Consequently, M3 growth slowed despite a significant increase in reserve money. This suggests that money supply growth was not a contributing factor to inflation. The monetary policy stance in 2010-11 was calibrated on the basis of the domestic growth-inflation dynamics amidst persistent global uncertainties. he 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 normalising 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 corporates has returned. With the growth expected to accelerate further in the next year, capacity constraints will reemerge, 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
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liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government borrowing programme is not hampered. On the basis of the current assessment and in line with the policy stance, the Reserve Bank implemented the following policy measures: Bank Rate y The Bank Rate has been retained at 6.0 per cent.
Repo Rate
y
Increased the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.0 per cent to 5.25 per cent.
Reverse Repo Rate
y
Increased the reverse repo rate under the LAF by 25 basis points from 3.5 per cent to 3.75 per cent.
Cash Reserve Ratio
y
Increased 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).
The result of the increase in the CRR is that about Rs. 12,500 crore of excess liquidity will be absorbed from the system By implanting these changes, the RBI was able to curb the inflation which is soaring and the growth rate can be sustained at the current level. Real GDP growth in 2010-11 reverted to near trend growth rate, following two successive years of below trend growth. Nonagricultural GDP growth, however,
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was slightly below the trend. The main impetus to the growth in 2010-11 came from agriculture which benefited from a normal monsoon, while industry and services registered mild deceleration. This moderation was primarily during the second half of the year due to the waning of the favorable base effect as well as deceleration in Government-spending related services. Growth is expected to stay near its trend during 2011-12 with upside factors such as buoyant private consumption demand and improved external demand getting counterbalanced by likely adverse impact from high fuel and commodity prices and prevailing risks to global growth from the debt crisis in parts of the Euro zone. Industrial growth decelerates on account of high base effect and moderation in investment demand. During 2010-11, the industrial sector exhibited signs of slowdown as the IIP growth moderated with intermittent episodes of volatility mainly on account of the high base effect and sharp deceleration in capital and intermediate goods which could partly be attributed to the moderation in investment demand in Q3 of 2010-11. The lower growth in IIP during AprilFebruary 2010-11 compared to the corresponding period of the previous year has been on account of the slowdown in growth of almost all the sectors except consumer goods. The contribution of intermediate and capital goods to the overall IIP growth declined, reflecting some moderation in investment demand. The continued high growth of consumer reflects consumption durables higher demand. segment private Amidst
slowdown, manufacturing activity spread more evenly. One notable feature of the pattern of IIP growth is that the activity in manufacturing sector has become more evenly spread with fifteen out of seventeen industries recording positive growth during April-February 2010-11. Moreover, the contribution of the bottom twelve industries to the
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overall IIP growth has increased. The recent IIP slowdown during the period November 2010 to February 2011 has been exacerbated by a few industries. If IIP growth is calculated after excluding the top 10 and the bottom 10 items that tend to disproportionately impact the overall IIP on account of wide volatility, the growth in February 2011 would be close to 8.8 per cent visà-vis 8.7 per cent in January 2011 and 11.2 per cent in February 2010. This suggests that the deceleration is not as pronounced as it may appear from the headline numbers. Nevertheless, the risk to industrial growth remains with deceleration in output of capital goods
During the period April 2010 to March 2011 RBI increased the Reverse Repo rate from 3.75 to 5.75 and the Repo Rate from 5.25 to 6.75 in order to curb the inflation. But this rate hike brought the investment in industries down but due to the high demand for automobiles and constructions the manufacturing segment was able to make an improvement. There have been significant changes in the drivers of inflation during 2010-11. First, while there are some signs of seasonal moderation in food prices, overall food inflation continues at an elevated level. It is likely that structural shortage of certain agricultural commodities such as pulses, edible oils and milk could reduce the pace of food price moderation. Second, the firming up of global commodity prices poses upside risks to inflation. Third, the Reserve Bank¶s industrial outlook survey shows that corporates are increasingly regaining their pricing power in many sectors. As the recovery gains further momentum, the demand pressures are expected to accentuate. Fourth, the Reserve Bank¶s quarterly inflation expectations survey for households indicates that household inflation expectations have remained at an elevated level
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The expected outcomes of the RBI¶s monetary policy were: (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. The key rate changes during the period 2010-11 can be referred from the table below
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Bibliography
http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=6376 http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=5602 http://stockthoughts.wordpress.com/2008/04/05/what-is-cash-reserve-ratio-and-howwill-the-crr-hike-impact-you/ http://www.banknetindia.com/ Baumol,Blinder et al (2009) Macroeconomics. Third Indian Reprint 2011, Nelson Education , Ltd. (CENGAGE Leanring)
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