Second Quarter Review of Monetary Policy

Following a return to some normalcy in forex markets and steps to contain the CAD on one hand and improve capital inflows on the other, the Q2 monetary policy review announced by RBI on October 29 marks further progress in rollback of exceptional liquidity mop-up measures and a return to those dictated by forces on domestic growth and inflation. Thus, the marginal standing facility (MSF) rate, or the bank rate which had become the effective anchor for money market rates recently, given the tight liquidity conditions in domestic markets, has been brought down to 8.75 per cent. Earlier, following a gradual return to stability in forex markets, the rate was reduced by 75 basis points in MQR on September 20 and by another 50 bps to 9 per cent on October 7.

At the same time, considering the persistently high WPI and CPI inflation, the LAF repo rate for injecting liquidity was hiked by another 25 bps to 7.75 per cent, with a reverse repo rate for withdrawing liquidity scaled up to 6.75 per cent. Thus, there is an interest rate corridor of 6.75-7.75-8.75 per cent in the new scenario for monetary policy operations. CRR is kept unchanged at 4 per cent.

Apart from these measures, taking cognizance of needs for some additional liquidity to meet growth requirements, the apex bank has hiked the cap on recently introduced variable rate term repos of 7-day and 14- day tenor from 0.25 per cent of net demand and time liabilities (NDTL) of the banking system to 0.5 per cent. RBI has also revised the timing of MSF operations, from 4.45-5.15 pm to 7.00-7.30 pm, which would help banks in their reserve management and assist free-up liquidity for the economy. It has also allowed banks to offer interest on savings and term rupee deposits at shorter than quarterly intervals.

DOWNWARD REVISIONS IN GDP PROJECTIONS FOR FY14 (%)
Agency
Latest Projection
Month/Year
Earlier Projection
Month/Year
Finance Ministry
5.0 to 5.5
September 2013
6.1 to 6.7
February 2013
PMEAC
5.3
September 2013
6.4
April 2013
IMF
4.3
October 2013
5.6
July 2013
World Bank
4.7
October 2013
5.7
June 2013
OECD*
5.3
May 2013
5.9
December 2012
ADB
4.7
October 2013
6
July 2013
NCAER
5.9
August 2013
6.2
May 2013
RBI
5
October 2013
5.7
April 2013
*: GDP at market prices.

Economic backdrop
Unlike countries which could go for quantitative easing to support growth on the back of deflation or very low inflation, India has faced markedly higher inflation, even while the economy has slowed down. This paradoxical situation and a fragile financial system have made the monetary policy task complex for RBI, necessitating the need to keep a watch on liquidity and the policy rates to anchor inflation expectations, and at the same time ensure stable macro-financial conditions and positive real returns to savers.

Globally, notwithstanding a distinct improvement in growth in the advanced economies, new risks to global recovery have arisen from fiscal discord in the USA and uncertainties arising from expectations related to withdrawal from unconventional monetary easing by advanced economies.

Domestically, while industrial activity has weakened, strengthening export growth, signs of revival in some services along with the expected pick-up in agriculture would likely increase the real GDP growth from 4.4 per cent in Q1 to a central estimate of 5.0 per cent for the year as a whole. CAD is likely to moderate in Q2 broadly in line with the narrower trade deficit. The trade balance has responded to the policy measures taken, especially as gold imports declined and exports picked up.

While the impact of actions of CCI and Project Monitoring Group in the PMO in accelerating key mega infrastructure projects is not immediately seen, concerted efforts over the next six months could bring about a turnaround in investment demand, says RBI.

On the inflation front, both wholesale and consumer prices are likely to remain elevated in the months ahead, warranting an appropriate policy response. Persistence in close to double digits CPI inflation remains a concern. A good kharif crop could partly mitigate the pressure on food prices, both at the wholesale and retail levels, whereas upside risks remain from short-term domestic supply-side disturbances, the possibility of unforeseen global oil price spikes and possible adverse currency movements. The apex bank has not explicitly given any estimate of WPI inflation for the year.

Enhanced focus on CPI
Even as RBI has traditionally looked at both the WPI and the CPI in its inflation management strategy, the exposition was on WPI. For the first time, the Q2 monetary policy review has brought CPI also into focus for public discussion. This probably was due to persistent close to double digit inflation in CPI.

Five pillars for developmental measures on the anvil:

a. Clarifying and strengthening the monetary policy framework.

b. Strengthening banking structure through new entry, branch expansion, encouraging new varieties of banks, and moving foreign banks into better regulated organisational forms.

c. Broadening and deepening financial markets and increasing their liquidity and resilience.

d. Expanding access to finance to small and medium enterprises, the unorganised sector, the poor, and remote and underserved areas of the country through measures to foster financial inclusion.

e. Improving the system’s ability to deal with corporate distress and financial institution distress by strengthening real and financial restructuring as well as debt recovery.


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