The Reserve Bank of India today released its Annual Report for 2007-2008.

Overall Performance

The Indian economy continued to perform well during 2007-08, although the growth moderated marginally. This was the third year in succession when the Indian economy achieved a growth rate of 9 per cent and above. This was also the highest average growth rate achieved during any three year period in the history of independent India. During each of the last three years, the growth rate of agriculture was well above the trend growth rate with foodgrains production touching a new high in each of the last two years.  Industry also registered robust growth with the growth rate in the previous year being in double digits. Services exhibited double digit growth in all the three years. Although the Indian economy has been generally performing well in the post-reform period, the performance during the last three years was indeed noteworthy and it was second only to China among the major countries,

The improved performance in the last three years was the result of the well thought out and calibrated reforms pursued in the various sectors during the last one decade and a half. The high growth rate was underpinned by a distinct improvement in the saving and investment rates mainly on account of a turnaround in the public sector saving rate and improvement in the corporate sector saving rates along with the sustained high saving rate of households. Under the rule-based fiscal consolidation programme, public sector savings witnessed a turnaround underpinned by a steady increase in the tax-GDP ratio and steady improvement in savings of non-departmental undertakings. This enabled a narrowing of public sector saving-investment gaps in recent years, thereby releasing greater resources for the private sector. A significant financial restructuring by the corporate sector and consequent reduction in the overall debt-equity ratio has had a significant impact on the profitability of the corporate sector and its savings. Household savings have been high traditionally in India and their contribution to overall savings has remained steady in recent years. Improved savings and generally comfortable financing conditions from the domestic and international capital markets drove the private investment rate above 10 per cent of GDP from 2004-05. Another major driver of the growth process has been improved levels of productivity as reflected in the stable and low incremental capital-output ratio. While studies show that both industry and services have recorded productivity gains, such gains have been more pronounced in respect of the services sector. Productivity gains in industry and services emanated from increased use of technology, reorientation of processes, increased capacity utilisation and continued restructuring of the corporate sector. 

The slight moderation in growth in 2007-08 in comparison with 2006-07 was mainly due to some adverse developments in the second half of the year. Growth decelerated sharply in the advanced industrial economies in the last quarter of 2007 mainly on account of turbulence in the international financial markets. Domestic inflation, which was well below the projections till December 2007, started hardening from January 2008, both on account of supply side pressures such as the one-off increase in domestic petrol and diesel prices, continuous hardening of prices of petroleum products that were not administered, rise in prices of wheat and oilseeds and adjustment in steel prices, and increased demand side pressures.  Concerns over slowdown in growth in relation to earlier expectations encouraged central banks in many advanced countries to reduce their policy rates. The resultant rise in liquidity led to a search of higher yields. India with strong macroeconomic fundamentals attracted large capital flows during 2007-08, driven by external commercial borrowings, portfolio flows and foreign direct investment (FDI) inflows. Capital flows significantly higher than the current account deficit (which widened on account of strong import demand and rise in crude oil prices) and hardening of inflation necessitated pre-emptive monetary policy actions to dampen excessive demand pressures, while providing a conducive environment for continuation of the growth momentum.

The short-term growth prospects are now faced with several downside risks, both global and domestic. Global economic conditions have worsened with the growth in major advanced economies decelerating and inflation hardening.  In India, headline industrial growth after a sustained expansion that began in 2003-04 moderated from September 2007.  Growth in the services sector has also showed some signs of moderation due mainly to somewhat lower growth in the financial and construction sub-sectors.  Inflation has hardened further even though the pass-through of the rise in international crude oil prices remains incomplete. Finances of the Government are under some stress on account of several factors such as increased pressures from oil, fertilisers and food subsidies, the farm loan waiver scheme and the hike in wages following the implementation of the Sixth Pay Commission recommendations.

Notwithstanding some downside risks to macroeconomic activity in the short run, the medium to long term prospects continue to remain robust. The structural factors underpinning the growth process continue to be as robust as before. The rise in saving and investment rates and gains in productivity experienced in recent years are likely to be sustained. Public finances, despite some underlying pressures, have remained broadly on the track so far as prescribed under the fiscal rules. The improvement in State finances, in particular, in recent years is encouraging. There has been a sharp improvement in the profitability, asset quality and soundness parameters of the banking sector. As a result, the banking sector has developed resilience and is better equipped to intermediate funds efficiently than before. The balance sheets of the corporate sector have also strengthened significantly over the years.  On the external sector front, although India's current account deficit has been widening, its robust macroeconomic fundamentals have ensured some capital inflows even during periods of heightened global uncertainty.

Although the medium to long-term prospects remain robust, there is a need to persist with the reform efforts in all the sectors of the economy to realise the full potential of the economy.

Assessment of 2007-08

Real GDP growth was placed at 9.0 per cent during 2007-08, moderating from 9.6 per cent recorded during 2006-07 and 9.4 per cent during 2005-06. However, it was still significantly higher than the average of 7.8 per cent achieved during the Tenth Plan (2002-2007). Growth in agriculture and allied activities recovered from 3.8 per cent in 2006-07 to 4.5 per cent in 2007-08, which was higher than the average growth of 4.0 per cent targeted for the Eleventh Plan (2007-2012). The overall foodgrains production was also estimated to touch an all-time peak of 230.7 million tonnes, underpinned by above normal and well distributed South-West Monsoon. Record high levels were touched by all foodgrains, led by pulses, coarse cereals and rice. Among non-food crops, oilseeds and cotton touched their peak levels, with the former witnessing particularly a significant increase. The industrial upturn, which started in April 2002 and peaked by the end of 2006-07, moderated during 2007-08. In terms of index of industrial production, industrial growth decelerated from 11.5 per cent in 2006-07 to 8.5 per cent in 2007-08. Manufacturing growth (9.0 per cent) was lower than in the preceding three years. The services sector continued to record double digit growth for the third successive year, notwithstanding some moderation (to 10.7 per cent in 2007-08 from 11.2 per cent in 2006-07).

Monetary Developments

Growth in money supply (M3) decelerated marginally from 21.5 per cent during 2006-07 to 20.8 per cent during 2007-08. Of the major components, buoyancy in time deposits continued during 2007-08, albeit there was some moderation in the last quarter of the year. Time deposits continued to grow at a robust rate, albeit somewhat lower than the last year. Demand deposits grew at a higher rate than in the previous year, with much of the expansion taking place in January and February 2008, when the equity market turned volatile. On the sources side, growth of bank credit moderated marginally during 2007-08, after three consecutive years of strong expansion. Demand for bank credit was broad-based with agriculture, industry and retail sectors absorbing bulk of the incremental expansion in overall non-food credit during 2007-08. Growth of credit to sectors such as commercial real estate remained high (y-o-y growth of 38 per cent at end-March 2008). Banks’ SLR investment, as a proportion of their net demand and time liabilities (NDTL), was 27.8 per cent at end-March 2008, almost the same level as at end-March 2007. Net foreign assets remained the key driver of reserve money.

Headline inflation, after easing up to an intra-year low of 3.1 per cent in mid-October 2007, increased subsequently to 7.7 per cent by end-March 2008, partly reflecting supply-side pressures on key agricultural commodities such as rice, wheat, oilseeds/edible oils, increase in iron and steel prices in line with international prices, partial pass-through of international crude oil prices to domestic prices and continued demand pressures. The increase in domestic primary food prices, however, was of a significantly lower order (6.5 per cent) compared with an increase of 45.3 per cent in international food prices, on a year-on-year basis in March 2008. Consumer price inflation, which had eased up to January 2008, increased subsequently mainly due to increase in food and services prices. Various measures of consumer price inflation at 6.0-7.9 per cent in March 2008 were placed lower as compared with 6.7-9.5 per cent a year earlier. In order to contain inflation and inflationary expectations, the Reserve Bank continued to take pre-emptive monetary actions in a calibrated manner in line with the evolving monetary and liquidity conditions. While leaving the liquidity adjustment facility (LAF) rates unchanged during the year, the Reserve Bank increased the cash reserve ratio by a further 150 basis points during 2007-08. The Government also took various fiscal measures during 2007-08 in the form of reduction in customs duties and restrictions on exports of few essential commodities to augment domestic supply and check price spirals, especially in food items.

Financial Markets

Global financial markets witnessed turbulent conditions during the most part of 2007-08 as losses on US sub-prime mortgage loans escalated into widespread financial stress, raising fears about stability of banks and other financial institutions. The crisis in the sub-prime mortgage market gradually deepened and spilled over to markets for other assets. Financial markets in India remained, by and large, orderly during 2007-08, barring the equity market, which witnessed occasional bouts of volatility during the second-half of August 2007, second-half of December 2007 and beginning the first week of January 2008 broadly in tandem with trends in international equity markets. The primary market segment of the capital market, which had witnessed increased activity till early January 2008, turned subdued thereafter due to volatility in the secondary market. Over the year, as a whole, however, the equity market registered further gains. Brief spells of volatility were observed in the money market on account of changes in capital flows and cash balances of the Central Government with the Reserve Bank. After the withdrawal of the ceiling on reverse repo acceptances under the liquidity adjustment facility (LAF) in August 2007, interest rates in overnight money markets moved broadly in the reverse repo and repo corridor for the most part of the year. Collateralised money market rates remained below the call rate during the year. In the foreign exchange market, the Indian rupee generally appreciated. Yields in the government securities market softened during the large part of the year.

Balance of Payments

India’s balance of payments remained comfortable during 2007-08.  Merchandise trade continued to exhibit robust growth during 2007-08. The growth in exports in recent years has been underpinned by structural factors like product diversification towards technology-intensive items as well as favourable terms of trade in respect of commodity exports amidst ongoing surge in their prices globally. India’s exports also witnessed geographical diversification, as a result of which the share of developing countries in India’s exports increased, while that of developed markets such as the European Union (EU) and the US declined. The growth of merchandise imports accelerated in the wake of an unprecedented rise in international crude oil prices and continued buoyancy in capital goods imports. Overall, higher import growth relative to exports in recent years has resulted in widening of the trade deficit, on a balance of payments basis.  However, net surplus under invisibles offset a large part of the trade deficit, thereby containing the current account deficit at 1.5 per cent of GDP in 2007-08 as compared with 1.1 per cent in 2006-07.  Net capital flows to India increased sharply to 9.2 per cent of GDP during 2007-08, which were 2.4 times higher than the level in 2006-07. Large net capital flows, which were significantly higher than the current account deficit, led to an accretion of foreign exchange reserves, placing continued pressure on monetary management.

Outlook for 2008-09

The global economy has continued to slow down during 2008 so far mainly due to slackness in growth in advanced economies such as the US, the UK and the Euro area. During 2008-09 (April-August), global financial markets witnessed generally uncertain conditions. Going forward, the overall balance of risks to the short-term global growth outlook remains tilted to the downside with growth in advanced economies expected to fall well below the potential. For monetary policy purposes, the Reserve Bank, in its Annual Policy Statement for 2008-09 (April 2008) had placed real GDP growth in the range of 8.0-8.5 per cent assuming that global financial and commodity markets and real economy would be broadly aligned with the central scenario; and domestically, normal monsoon conditions would prevail. The Reserve Bank in its First Quarter Review of the Annual Statement of Monetary Policy (July 2008) indicated that taking into account aggregate demand and supply prospects, for policy purposes, a projection of around 8.0 per cent for real GDP growth appeared a more realistic central scenario, barring domestic or external shocks.

Expansion of money supply (M3), (y-o-y), as on August 1, 2008 (19.6 per cent) was lower than a year ago (21.8 per cent), but  higher than the indicative projection of 17.0 per cent set out in the  First Quarter Review of Annual Statement on Monetary Policy (July 2008). Growth of aggregate deposits decelerated due to deceleration in both demand and time deposits. Growth in bank credit, on the other hand, accelerated with growth in non-food credit of scheduled commercial banks (SCBs), y-o-y, placed at 26.2 per cent on August 1, 2008 as compared with 23.5 per cent a year ago. Accordingly, the incremental credit-deposit ratio of SCBs rose to 86.0 per cent from 67.2 per cent a year ago. Investments in SLR securities by SCBs were at 27.0 per cent of their net demand and time liabilities on August 1, 2008 (27.8 per cent at end-March 2008) as compared with 28.6 per cent a year ago. Growth of reserve money, y-o-y, as on August 15, 2008 at 31.1 per cent (24.3 per cent adjusted for the first round impact of increases in the CRR) was higher than 24.1 per cent (14.2 per cent adjusted for the first round effect of increases in CRR) a year ago.

Headline inflation firmed up further to 12.6 per cent on August 9, 2008 from 7.7 per cent at end-March 2008 (and 4.2 per cent a year ago), partly reflecting the impact of another round of upward revision in the prices of administered petroleum products such as petrol, diesel and LPG as well as increase in prices of freely-priced petroleum products. Apart from fuel prices, the intermittent but sharp increase in basic metals prices in line with international trends, along with iron ore prices, were the other major factors that have contributed to inflation during 2008-09 so far. Manufactured products inflation hardened to 10.9 per cent on August 9, 2008 from 7.3 per cent at end-March 2008 (and 4.7 per cent a year ago) which, apart from metals, was due to increase in the prices of edible oils and oil cakes as well as recent firming up of textiles prices. Primary articles inflation firmed up to 11.8 per cent on August 9, 2008 from 9.7 per cent at end-March 2008, driven by the hardening of vegetables, raw cotton and oilseeds prices. Various measures of consumer price inflation were placed higher (7.3-9.4 per cent) in June/July 2008 than those in March 2008 (6.0-7.9 per cent).

In view of the lagged and cumulative effects of monetary policy on aggregate demand and assuming that supply management would be conducive, capital flows would be managed actively and in the absence of adversities emanating in the domestic or global economy,  the Annual Policy Statement in April 2008 noted that the policy endeavour would be to bring down inflation from the then high level of above 7.0 per cent to around 5.5 per cent in 2008-09 with a preference for bringing it as close to 5.0 per cent as soon as possible, while recognising the evolving complexities in globally transmitted inflation. According to the First Quarter Review while the policy actions would aim to bring down the prevailing intolerable level of inflation to a tolerable level of below 5.0 per cent as soon as possible and around 3.0 per cent over the medium-term, a realistic policy endeavour would be to bring down inflation from the then prevailing level of about 11.0-12.0 per cent to a level close to 7.0 per cent by March 31, 2009.

The overall stance of monetary policy in the Annual Policy Statement was stated broadly to ensure a monetary and interest rate environment that accorded high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to the continuation of the growth momentum. The First Quarter Review, while reiterating the Annual Policy stance for 2008-09, noted that there was an urgent need for monetary policy to address aggregate demand pressures, which were strongly in evidence, by continuing with measured responses on an ongoing basis, in a timely manner. Various measured responses beginning September 2004, which had moderated early signs of overheating that emerged in 2006-07, would continue to work in conjunction with supply side measures to bring down inflation to more acceptable levels in the near future. 

REAL SECTOR

Agriculture

The ongoing surge in global prices of major food items, which began in 2006, has significant implications for the domestic agricultural sector and overall macroeconomic and financial stability. Food prices have also hardened in India recently but the increase in wholesale prices of various crops in India has been of a much lower order in comparison with the increase in global food prices.

In India, although the share of agriculture in real GDP has declined below one-fifth, it continues to be an important sector as it employs 52 per cent of the workforce. Boosting agricultural production, through increase in gross cropped area (multiple cropping), enhancement in irrigation coverage and improvement in productivity, has remained a challenge in the wake of flattening out of increase in net sown area. Furthermore, actual yields also lag the levels, which could be possible through improved practices, as noted by the Steering Committee on Agriculture for the Eleventh Plan. While trade and fiscal measures along with imports can address supply-demand mismatches in the short run, in the medium to long run, there is a need to ensure that domestic food management enables maintenance of adequate levels of buffer stocks.  Going forward, the overall improvement in foodgrains production and the rise in the level of buffer stocks would assuage supply shortages, dampen inflation expectations, economise on imports and fortify food security in the context of the intensifying food crisis worldwide. However, there is a need to carefully avoid the possible unintended consequences of building up buffer stocks for market supplies at a time when demand-supply gaps are already strained, while ensuring food security and maintaining price stability.

The long-term solution lies in addressing structural weaknesses in agriculture such as exhaustion of yield potential of high yielding varieties of rice and wheat, unbalanced fertiliser use,  low seeds replacement rate, inadequate incentive system and post harvest value addition. Going forward, in order to reap the full potential in agriculture, greater focus needs to be placed on modernising the agricultural research system as success so far has been restricted to select crops. Investment in agriculture needs to be raised substantially. There is a need to promote agriculture diversification towards horticulture and livestock.  There is also need to recognise the benefits of collective representation of farmers in the product and credit markets. It is imperative to ensure the efficient use of inputs such as water resources, seeds and fertilisers. For this purpose, farmers, if necessary, may be imparted necessary training by the local administration and research institutes. Despite significant increase in agricultural production, goals of self-sufficiency in food, food security and nutrition at the household level are yet to be achieved. The challenge, thus, lies in continuously working towards implementing the Government’s strategy of faster and more inclusive growth in its multiple dimensions.

Industry and Infrastructure

Industrial growth, which accelerated during the period 2002-03 to 2006-07, moderated in 2007-08, reflecting, apart from the base effect, some slowing down of domestic and external demand. Hardening of crude oil prices and spikes in commodity prices, which form inputs for the industrial sector, increased the costs of industrial production. Hardening of crude oil prices and spikes in commodity prices, which form inputs for the industrial sector, increased the costs of industrial production. The industrial sector faced several supply constraints emanating from the shortages in the cement and steel sectors, which were reflected in a spurt in their prices. Other constraints included industry-specific capacity limitations, inadequate power availability, transportation bottlenecks and other infrastructural services, which exerted pressure on the output.

Performance of the infrastructure sector continues to be an area of concern. The performance of the electricity sector was adversely affected by capacity constraints, which were caused, inter alia, by problems relating to coal and ash handling units, and water availability. Such issues restrained the operationalisation of new units commercially and hampered power generation in both thermal and hydro plants. The slow progress in capacity additions has accentuated the power supply deficits and any slippage in achieving the targets may worsen the situation further in the face of increasing demand for power from industry and other sectors. While measures have been initiated to increase the coal production to meet the growing demand not only from the electricity sector but also from other utilities, environmental concerns and issues relating to rehabilitation of displaced population due to mining activities and construction of dams also need to be addressed proactively. In view of shortages and rising prices of petroleum products in recent times, keen interest is being shown globally in setting up of thermal power plants that are not based on oil. As such thermal plants are dependent on coal and gas, the thermal based additions to capacity in India would have implications for the cost of power generation due to increasing prices of gas and coal, and erratic gas supplies would lower plant load factor. Besides, a rise in mineral oil prices could also have an impact on gas prices, which would hamper the production of power. At the margin, renewable energy sources offer an alternative for meeting the growing demand for power.

Services

The service sector recorded double digit growth during the last three year period 2005-06 to 2007-08, underpinned by a significant increase in demand for domestic services. The performance of the services sector in recent years has been robust. However, rise in international mineral oil prices poses a downside risk to the outlook. Rise in mineral prices may particularly affect the performance of the transport sector, which had 10.4 per cent weight in the services sector and constituted 6.4 per cent of GDP in 2006-07.  A sharp increase in input prices of aviation fuels and petroleum products may also impinge on the pace of growth of this sector. The tourism sector, which heavily relies on various transport services, could also be impacted as tour package costs would soar impacting the hotel industry. Furthermore, as the services sector derives its demand to a large extent from the industrial sector, moderation in the industrial growth momentum might also impact the services sector growth prospects.

The global slowdown raises uncertainties about prospects of external demand for both the industry and services sectors in India. Although Indian industry remains primarily domestic demand driven, there are some industries, including gems and jewellery, textiles and engineering goods which have higher dependence on external demand conditions. In the event of some export demand compression for some of India's manufactured exportable items, there could be some impact on certain segments of manufacturing. In respect of the services, only specific sectors, which have significant dependence on global markets, could be affected with the onset of recession in the global economy. In particular, the global recession could impact the trade sector, which, in turn, could affect the performance of the transportation sector. Further, recession could also limit business and leisure tourism, which, in turn, could have implications for the performance of hotels. Indian ITES-BPO industry remains highly dependent on external market conditions as India's ITES exports account for about two-thirds of its ITES-BPO revenues. The impact of recession on Indian ITES and BPO services, however, remains uncertain.

FISCAL POLICY

The Central Government was mandated under the FRBM Act to reduce its gross fiscal deficit-GDP ratio to three per cent and eliminate its revenue deficit by 2008-09. The fiscal correction process was set to continue in 2008-09 in tune with the legislative mandate with the Centre's gross fiscal deficit-GDP ratio budgeted to decline to 2.5 per cent during 2008-09. It, however, budgeted revenue deficit-GDP ratio at 1.0 per cent and rescheduled its elimination by 2009-10, primarily in order to meet the necessary requirements of revenue expenditure-intensive programmes, particularly at the commencement of the Eleventh Five Year Plan. The systemic rigidity of non-Plan committed expenditures in the short run was another contributory factor.

The management of public finances during the last four years, mandated under FRBM Act, 2003, has been broadly on track so far. The robust economic growth resulted in higher than anticipated tax revenues and created fiscal space for meeting the demand for resources. The revenue-led consolidation reflected the combined effect of a balanced and reasonable tax rate structure with fewer exemptions and wider coverage of tax base, and efficiency of tax administration. The ongoing reforms and fiscal correction initiatives, in turn, supported domestic demand and investment, thereby propelling economic growth. Notwithstanding the improved position, there are several underlying fiscal pressures that are not entirely evident in the headline fiscal indicators. Although the implementation of fiscal rules has had a positive effect of focusing attention on fiscal issues, there has been an increased recourse to other fiscal liabilities. The issuance of bonds has been resorted to frequently for financing not only fuel, food and fertiliser subsidies, but also deferred liabilities with regard to bank loan waivers and contribution to  capital of public sector banks. Although the issuance of such bonds does not directly increase the conventionally measured fiscal deficit, the proceeds from such bonds are used to effectively fund current subsidy expenditures. Their macroeconomic and financial market impacts and crowding out of resource availability to the private sector are similar to an expansion of the fiscal deficit. The significant quasi-fiscal transactions to finance recurrent revenue expenditures through de facto borrowings also create apprehensions about the quality of the fiscal consolidation process that is underway and poses challenges for fiscal, external and monetary management.

While the need to eliminate revenue deficit and target a nominal limit on fiscal deficit is important, the mode of financing of the fiscal deficit and the appropriate use of resources so raised are equally important, particularly in the context of pressing requirements for adequate investment in social and financial infrastructure. Furthermore, there is a need to work towards durable fiscal correction and consolidation through fiscal empowerment, i.e., by expanding the scope and size of revenue flows. Exclusive focus on fiscal deficit may tend to reduce the role of the Government, thereby hampering the process of growth, especially when the focus is on inclusive growth. The Indian economy is undergoing structural transformation and it needs large investments in social and physical infrastructure. There is, therefore, a need to step up investment in certain critical areas such as education, health care and physical infrastructure. The role of fiscal authority also assumes importance in the light of ongoing financial turbulence across the world as it must be recognised that when everything else fails, it is only the fisc that has to take the hit and come to rescue.

EXTERNAL SECTOR

India's balance of payments is increasingly being influenced by global developments, reflecting its growing linkages with the rest of the world through real as well as financial flows. The ratio of merchandise exports to GDP has risen since the early 1990s. During 2002-2007, India's export growth was placed higher than its key competitors in the Asian region (except China). Simultaneously, import intensity has also risen steadily as domestic entities have expanded access to internationally available raw material and intermediate goods as well as quality inputs for providing the cutting edge to domestic production and export capabilities. Services exports, led by buoyancy in software and business services, and overseas remittances, have progressively become larger and more stable since the mid-1990s, thereby imparting resilience to India's invisible receipts. The net invisibles surplus has offset a significant part of the expanding trade deficit and helped in containing the current account deficit to an average of around one per cent of GDP since the early 1990s. With regard to the capital account also, India's linkages with the global economy are getting stronger, underpinned by the growing openness of the economy and two way movement in financial flows. In the capital account, the liberalised external payments regime has been facilitating the process of acquisition of foreign companies by Indian corporates, both in the manufacturing and services sectors, with the objectives of reaping economies of scale, access to technology knowhow and capturing offshore markets to face the global competition. Notwithstanding outflows, capital inflows (net) the period 2003-2008 on an average during remained higher than the average for any five-year period in the independent India. Persistently large capital inflows (net) above the current account deficit would also complicate the task of monetary and liquidity management, particularly in the face of liquidity pressures.

In the medium term, the continued focus on financial market development could potentially mitigate the challenge of capital flows. However, it is important to recognise that the development of financial markets is a gradual process. Hence, while continuing to work on development of the financial markets, capital flows have to be managed through other tools in the short term. The gradual process of fuller capital account liberalisation could be pursued over the medium-term, keeping in view, particularly, the issues raised by recent financial market turbulence in advanced economies. Therefore, the issue is not either financial market development or management of capital account, but how much of each approach should be adopted in a given situation and over time while recognising and taking into account the scope and prospects for reforms in fiscal and real sectors. 

The overall approach to the management of India's foreign exchange reserves would continue to take into account the changing composition of the balance of payments and endeavour to reflect the 'liquidity risks' associated with different types of flows and other requirements.  Furthermore, the reserves would continue to be invested in major economies, adhering to the principles of according priority to safety, liquidity and return. As regards the reserve management, a related issue is the valuation of foreign reserves on a marked-to-market basis on the balance sheet of the Reserve Bank. In this regard, the Reserve Bank has adopted a conservative accounting practice, whereby unrealised gains are not shown, while losses are booked.

FINANCIAL SECTOR

In recent years, the Reserve Bank has emphasised credit quality, improvement of the credit delivery system (with specific focus on agriculture, micro, small and medium enterprises) and financial inclusion. There has been significant increase in the credit flow to agriculture, small and medium enterprises and crop loans at administered interest rates. Various measures such as one-time settlement (OTS) and rescheduling/restructuring schemes for distressed farmers, simplification of procedures, adoption of business correspondent model and the use of smart cards have also facilitated increased credit to the rural sector. Furthermore, the linking of credit to a broader base of adjusted net bank credit, including their non-SLR investments, in respect of priority sector targets, also seeks to promote credit to the priority sectors. While concessional credit and debt relief are intended to alleviate farmers' distress and reopen the credit lines that have been choked, sustaining an appropriate credit culture going forward would require incentive systems for greater flow and efficient allocation of credit. In consonance with the policy emphasis on gradual harmonisation with the international best practices, foreign banks operating in India and Indian banks having presence outside India have already migrated to the standardised approach for credit risk and the basic indicator approach for operational risk under Basel II with effect from March 31, 2008. All other scheduled commercial banks would migrate to these approaches under Basel II not later than March 31, 2009. The Pillar 2 guidelines were issued during the year. Certain amendments were also carried out in the Basel II framework issued earlier. Newer avenues of raising capital were provided to banks to accord them with greater flexibility in meeting the Basel II requirement. Special emphasis was laid on liquidity and asset liability management. The policy initiatives also focussed on strengthening the corporate governance practices in banks and improving customer service.

In contrast to the global situation, India has been, by and large, spared of global financial contagion resulting from the sub-prime turbulence for a variety of reasons. A few instances of pre-emptive regulation to ensure financial stability include, inter alia, prescription of a Board mandated policy in respect of real estate exposure of banks and increasing risk weights for various segments of the financial sector, provisioning against standard assets, norms on exposure to inter-bank liability, norms on financial regulation of systemically important NBFCs and banks' relationship with them, norms for securitisation and non-SLR investments and marking-to-market valuation norms. The regulatory guidelines are supplemented by moral suasion and supervisory review.  The Reserve Bank's broad approach to financial sector reforms has been to develop institutional and financial infrastructure and lay down appropriate regulatory and supervisory regime to ensure financial stability consistent with the overall objectives of growth with price stability. The pace of reforms has been contingent upon putting in place appropriate systems and procedures, technologies and market practices. In recent years, a new challenge for the financial sector in the context of inclusive growth is how to extend itself and innovate to meet the demands for financial inclusion and respond adequately to new opportunities and risks. Innovative channels for credit delivery for serving the new credit needs need to be developed, perhaps with greater use of information technology and intensified skills development in human capital.

MONETARY POLICY

The monetary policy stance of withdrawing monetary accommodation continued during 2007-08. In view of unprecedented turbulence in global financial markets since end-July 2007 following the sub-prime crisis and the unconventional policy response of major central banks, monetary policy resolved to be vigilant and proactive in cushioning the real economy from excess volatility in financial markets (October 2007/January 2008). This warranted more intensified monitoring and swift responses with all the available instruments to preserve and maintain domestic macroeconomic and financial stability. While domestic factors dominated the policy stance, monetary policy recognised the risks to inflation from high and volatile international food, fuel and metal prices.  In view of these factors, the stance of monetary policy in January 2008 focused on swift response to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate on a continuing basis. In view of heightened global uncertainties and mounting inflationary pressures from escalated and volatile food and energy prices, which possibly contained some structural components, and persistence of demand pressures, albeit with some improvement in supply response, monetary policy in April 2008 noted that while it had to respond proactively to immediate concerns, it could not afford to ignore considerations over a longer term perspective with respect to overall macroeconomic prospects. Accordingly, the Reserve Bank emphasised the need to demonstrate on a continuing basis the determination to act decisively, effectively and swiftly to curb any signs of adverse developments with regard to inflation expectations. In view of unprecedented uncertainties and dilemmas, it also emphasised the importance of taking informed judgements with regard to the timing and magnitude of policy actions based on an evaluation of incoming information on a continuous basis.

In line with the stance set out in April 2008, monetary policy underlined the need to eschew any further intensification of inflationary pressures and firmly anchor inflation expectations. Mirroring inflation trends in many advanced as well as emerging economies, inflation in India also hardened significantly in recent months above the Reserve Bank's tolerable level, amidst strong evidence of aggregate demand pressures, exacerbated by the slack in the supply response. Recognising that high and volatile energy prices were not a temporary phenomenon and the evolving complexities in globally transmitted inflation, the First Quarter Review (July 2008) accorded the highest priority to bringing down inflation from the prevailing high levels to a level close to 7.0 per cent by end-March 2009 and stabilising inflationary expectations.

The conduct of monetary policy has become more challenging recently for a variety of factors. First, it is necessary to recognise the global dimensions of the crisis, which is threatening the credibility of monetary policy world wide. Second, localised factors such as banks' balance sheet adjustments in the run-up to the year-end closure of accounts and advance tax flows have also influenced liquidity conditions. Third, the evolving fiscal situation in an atmosphere of persistent inflationary pressures poses severe challenges to monetary management, especially if supply inelasticities continue to prevail in the short-term. Thus, there is a need to ensure that effectiveness of monetary policy is not undermined by fiscal expansion. Fourth, it is necessary to recognise that monetary policy has also to reckon with the structural components embedded in the drivers of inflation which, unlike cyclical elements, are somewhat impervious in the short run to instruments of aggregate demand management. Fifth, it needs to be recognised that existence of stipulated SLR prescription of 25 per cent of net domestic demand and time liabilities of banks hampers the genuine development of the government securities market. Sixth, the heightened uncertainty surrounding global financial markets and the unusual policy responses of major central banks suggest that the threats to global growth and stability that loom over the near-term horizon, continue to be significant, for the evolving monetary policy stance in 2008-09. Seventh, although growth rates of monetary and banking aggregates have started to dip since June 2008 in line with the projected trajectories, the demand for bank credit continues to be strong. Finally, the continued dominance of administered interest rates in some form or the other indicates that the extent of monetary policy measures needs to take cognisance of rigidities in transmission on this account.

As the inflation rates have hardened beyond tolerable levels, monetary policy would continue to address aggregate demand pressures which appear to be strongly in evidence. However, at the same time, there is need to improve supply position in some critical sectors. In order to tackle food price inflation, the demand-supply mismatches need to be addressed over the medium term, which, would necessitate raising crop yields through the use of modern technology, improved irrigation facilities as well as provision of market-based incentive systems for the farmers both in the credit and product markets. An overriding priority for monetary policy would be to eschew any further intensification of inflationary pressures. 

Alpana Killawala
Chief General Manager

Press Release: 2008-2009/261