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FUNCTIONS
CREDIT POLICY AND ITS
IMPLICATIONS
SUBMITTED TO:
The project on ‘Central Bank and its functions, Credit policy and its implications’ is designed
to provide the reader with an insight into the various functions of the RBI and the credit
policy and its implications. The subject matter is very comprehensive and gives the idea of
the few aspects of central bank.
OBJECTIVE – Since we all are MBA students and are aspiring to be managers,
knowing about the various aspects of The Reserve Bank of India is an important part of our
studies. This project will help in understanding all the factors.
3. HISTORY
4. STRUCTURE
5. FUNCTIONS
6. CREDIT POLICY
CENTRAL BANK
A central bank, reserve bank, or monetary authority is a banking institution granted the
exclusive privilege to lend a government its currency. However, a central bank is
distinguished from a normal commercial bank because it has a monopoly on creating the
currency of that nation, which is loaned to the government in the form of legal tender. It is a
bank that can lend money to other banks in times of need.
Its primary function is to provide the nation's money supply, but more active duties include
controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking
sector during times of financial crisis (private banks often being integral to the national
financial system). It may also have supervisory powers, to ensure that banks and other
financial institutions do not behave recklessly or fraudulently.
Reserve Bank of India was nationalised in the year 1949. The general superintendence and
direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor
and four Deputy Governors, one Government official from the Ministry of Finance, ten
nominated Directors by the Government to give representation to important elements in the
economic life of the country, and four nominated Directors by the Central Government to
represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New
Delhi. Local Boards consist of five members each Central Government appointed for a term
of four years to represent territorial and economic interests and the interests of co-operative
and indigenous banks. During the past 99 years of history the Bank has weathered many
storms and faced many challenges. The Bank could successfully transform every threat into
business opportunity and excelled over its peers in the Banking industry. Further in line with
the guidelines from Reserve Bank of India as also the Government of India, Central Bank has
been playing an increasingly active role in promoting the key thrust areas of agriculture,
small scale industries as also medium and large industries. The Bank also introduced a
number of Self Employment Schemes to promote employment among the educated youth.
The RBI was first established in 1935 and is responsible for setting the overnight interbank
lending rate and creating financial stability in the country. This overnight rate is known as
the Mumbai Interbank Offer Rate (MIBOR) and it serves as the benchmark for interest rates
in India. Without the RBI, the credit markets would not function properly and the flow of
currency in the country would dry up.
Preamble
The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank
as:
"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of the
country to its advantage."
Corporate vision
To emerge as a strong, vibrant and pro-active Bank/Financial Super Market and to positively
contribute to the emerging needs of the economy through consistent harmonization of human,
financial and technological resources and effective risk control systems.
Corporate mission
• To transform the customer banking experience into a fruitful and enjoyable one.
• To leverage technology for efficient and effective delivery of all banking services.
• To have bouquet of product and services tailor-made to meet customers aspirations.
• The pan-India spread of branches across all the state of the country will be utilized to
further the socio economic objective of the Government of India with emphasis on
Financial Inclusion.
Central Bank of India, a government-owned bank, is one of the oldest and largest commercial
banks in India based in Mumbai. The bank currently has 3,563 branches and 270 extension
counters across 27 Indian states.
• Mr S Sridhar has been appointed as the Chairman and Managing Director of state-run
Central Bank of India as on 2 March 2009.
• Central bank of India is one of 18 Public Sector banks in India to get recapitalisation
finance from the government over the next 24 months. The infusion of fund will
improve the financial health of the banks as their capital adequacy ratio (CAR) will be
raised more than desired level of 12 percent. The increase in CAR of the banks will
also enable them to lend more money.
• The wholly-owned public sector bank, based in Mumbai, will convert an amount of
Rs. 800 crore out of its Rs. 1,124.14-crore total equity capital into perpetual non-
cumulative preference shares.
• At a time when the global banking industry is feeling the pinch of the global credit
crunch, Central Bank of India is planning to expand its foreign presence. The public-
sector lender has approached the Reserve Bank of India (RBI) for permission to open
representative offices in five locations - Singapore, Dubai, Doha, London and Hong
Kong.
1950 - 1960
Between 1950 and 1960, the Indian government developed a centrally planned economic
policy and focused on the agricultural sector. The administration nationalized commercial
banks and established, based on the Banking Companies Act, 1949 (later called Banking
Regulation Act) a central bank regulation as part of the RBI. Furthermore, the central bank
was ordered to support the economic plan with loans.
1960 - 1969
As a result of bank crashes, the reserve bank was requested to establish and monitor a deposit
insurance system. It should restore the trust in the national bank system and was initialized on
7 December 1961. The Indian government founded funds to promote the economy and used
the slogan Developing Banking. The Gandhi administration and their successors restructured
the national bank market and nationalized a lot of institutes. As a result, the RBI had to play
the central part of control and support of this public banking sector.
1969–1985
Between 1969 and 1980 the Indian government nationalized 20 banks. The regulation of the
economy and especially the financial sector was reinforced by the Gandhi administration and
their successors in the 1970s and 1980s. The central bank became the central player and
increased its policies for a lot of tasks like interests, reserve ratio and visible deposits. The
measures aimed at better economic development and had a huge effect on the company
policy of the institutes. The banks lent money in selected sectors, like agri-business and small
trade companies.
The branch was forced to establish two new offices in the country for every newly
established office in a town. The oil crises in 1973 resulted in increasing inflation, and the
RBI restricted monetary policy to reduce the effects.
1985–1991
A lot of committees analysed the Indian economy between 1985 and 1991. Their results had
an effect on the RBI. The Board for Industrial and Financial Reconstruction, the Indira
Gandhi Institute of Development Research and the Security & Exchange Board of India
investigated the national economy as a whole, and the security and exchange board proposed
better methods for more effective markets and the protection of investor interests. The Indian
financial market was a leading example for so-called "financial repression" (Mackinnon uand
Shaw). The Discount and Finance House of India began its operations on the monetary
market in April 1988; the National Housing Bank, founded in July 1988, was forced to invest
in the property market and a new financial law improved the versatility of direct deposit by
more security measures and liberalisation.
1991–2000
The national economy came down in July 1991 and the Indian rupee was devalued. The
currency lost 18% relative to the US dollar, and the Narsimahmam Committee advised
restructuring the financial sector by a temporal reduced reserve ratio as well as the statutory
liquidity ratio. New guidelines were published in 1993 to establish a private banking sector.
This turning point should reinforce the market and was often called neo-liberal. The central
bank deregulated bank interests and some sectors of the financial market like the trust and
property markets. This first phase was a success and the central government forced a
diversity liberalisation to diversify owner structures in 1998.
The National Stock Exchange of India took the trade on in June 1994 and the RBI allowed
nationalized banks in July to interact with the capital market to reinforce their capital base.
The central bank founded a subsidiary company—the Bharatiya Reserve Bank Note Mudran
Limited—in February 1995 to produce banknotes.
Since 2000
The Foreign Exchange Management Act from 1999 came into force in June 2000. It should
improve the foreign exchange market, international investments in India and transactions.
The RBI promoted the development of the financial market in the last years, allowed online
banking in 2001 and established a new payment system in 2004 - 2005 (National Electronic
Fund Transfer). The Security Printing & Minting Corporation of India Ltd., a merger of nine
institutions, was founded in 2006 and produces banknotes and coins. The national economy's
growth rate came down to 5,8% in the last quarter of 2008 - 2009 and the central bank
promotes the economic development.
STRUCTURE
The Central Board of Directors is the main committee of the central bank and has not more
than 20 members. The government of the republic appoints the directors for a four year term.
Name Position
The Bank has also two training colleges for its officers, viz. Reserve Bank Staff College at
Chennai and College of Agricultural Banking at Pune. There are also four Zonal Training
Centres at Belapur, Chennai, Kolkata and New Delhi.
• Bank of Issue
Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank
notes of all denominations. The distribution of one rupee notes and coins and small coins all
over the country is undertaken by the Reserve Bank as agent of the Government. The Reserve
Bank has a separate Issue Department which is entrusted with the issue of currency notes.
The assets and liabilities of the Issue Department are kept separate from those of the Banking
Department. Originally, the assets of the Issue Department were to consist of not less than
two-fifths of gold coin, gold bullion or sterling securities provided the amount of gold was
not less than Rs. 40 crores in value. The remaining three-fifths of the assets might be held in
rupee coins, Government of India rupee securities, eligible bills of exchange and promissory
notes payable in India. Due to the exigencies of the Second World War and the post-war
period, these provisions were considerably modified. Since 1957, the Reserve Bank of India
is required to maintain gold and foreign exchange reserves of Ra. 200 crores, of which at
least Rs. 115 crores should be in gold. The system as it exists today is known as the minimum
reserve system.
• Banker to Government
The second important function of the Reserve Bank of India is to act as Government banker,
agent and adviser. The Reserve Bank is agent of Central Government and of all State
Governments in India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business, via. to keep the cash balances as deposits free of
interest, to receive and to make payments on behalf of the Government and to carry out their
exchange remittances and other banking operations. The Reserve Bank of India helps the
Government - both the Union and the States to float new loans and to manage public debt.
The Bank makes ways and means advances to the Governments for 90 days. It makes loans
and advances to the States and local authorities. It acts as adviser to the Government on all
monetary and banking matters.
The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible
securities or get financial accommodation in times of need or stringency by rediscounting
bills of exchange. Since commercial banks can always expect the Reserve Bank of India to
come to their help in times of banking crisis the Reserve Bank becomes not only the banker's
bank but also the lender of the last resort.
• Controller of Credit
The Reserve Bank of India is the controller of credit i.e. it has the power to influence the
volume of credit created by banks in India. It can do so through changing the Bank rate or
through open market operations. According to the Banking Regulation Act of 1949, the
Reserve Bank of India can ask any particular bank or the whole banking system not to lend to
particular groups or persons on the basis of certain types of securities. Since 1956, selective
controls of credit are increasingly being used by the Reserve Bank.
The Reserve Bank of India is armed with many more powers to control the Indian money
market. Every bank has to get a licence from the Reserve Bank of India to do banking
business within India, the licence can be cancelled by the Reserve Bank of certain stipulated
conditions are not fulfilled. Every bank will have to get the permission of the Reserve Bank
before it can open a new branch. Each scheduled bank must send a weekly return to the
Reserve Bank showing, in detail, its assets and liabilities. This power of the Bank to call for
information is also intended to give it effective control of the credit system. The Reserve
Bank has also the power to inspect the accounts of any commercial bank.
As supreme banking authority in the country, the Reserve Bank of India, therefore, has the
following powers:
(a) It holds the cash reserves of all the scheduled banks.
(b) It controls the credit operations of banks through quantitative and qualitative controls.
(c) It controls the banking system through the system of licensing, inspection and calling for
information.
(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.
• Supervisory functions
In addition to its traditional central banking functions, the Reserve bank has certain non-
monetary functions of the nature of supervision of banks and promotion of sound banking in
India. The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949 have given the
RBI wide powers of supervision and control over commercial and co-operative banks,
relating to licensing and establishments, branch expansion, liquidity of their assets,
management and methods of working, amalgamation, reconstruction, and liquidation. The
RBI is authorised to carry out periodical inspections of the banks and to call for returns and
necessary information from them. The nationalisation of 14 major Indian scheduled banks in
July 1969 has imposed new responsibilities on the RBI for directing the growth of banking
and credit policies towards more rapid development of the economy and realisation of certain
desired social objectives. The supervisory functions of the RBI have helped a great deal in
improving the standard of banking in India to develop on sound lines and to improve the
methods of their operation.
• Promotional functions
With economic growth assuming a new urgency since Independence, the range of the
Reserve Bank's functions has steadily widened. The Bank now performs a variety of
developmental and promotional functions, which, at one time, were regarded as outside the
normal scope of central banking. The Reserve Bank was asked to promote banking habit,
extend banking facilities to rural and semi-urban areas, and establish and promote new
specialised financing agencies. Accordingly, the Reserve Bank has helped in the setting up of
the IFCI and the SFC; it set up the Deposit Insurance Corporation in 1962, the Unit Trust of
India in 1964, the Industrial Development Bank of India also in 1964, the Agricultural
Refinance Corporation of India in 1963 and the Industrial Reconstruction Corporation of
India in 1972. These institutions were set up directly or indirectly by the Reserve Bank to
promote saving habit and to mobilise savings, and to provide industrial finance as well as
agricultural finance. As far back as 1935, the Reserve Bank of India set up the Agricultural
Credit Department to provide agricultural credit. But only since 1951 the Bank's role in this
field has become extremely important. The Bank has developed the co-operative credit
movement to encourage saving, to eliminate moneylenders from the villages and to route its
short term credit to agriculture. The RBI has set up the Agricultural Refinance and
Development Corporation to provide long-term finance to farmers.
Monetary Authority
The Reserve Bank of India is the main monetary authority of the country and beside that the
central bank acts as the bank of the national and state governments. It formulates, implements
and monitors the monetary policy as well as it has to ensure an adequate flow of credit to
productive sectors. Objectives are maintaining price stability and ensuring adequate flow of
credit to productive sectors. The national economy depends on the public sector and the
central bank promotes an expensive monetary policy to push the private sector since the
financial market reforms of the 1990s.
The institution is also the regulator and supervisor of the financial system and prescribes
broad parameters of banking operations within which the country's banking and financial
system functions. Objectives are to maintain public confidence in the system, protect
depositors' interest and provide cost-effective banking services to the public.
Developmental role
The central bank has to perform a wide range of promotional functions to support national
objectives and industries. The RBI faces a lot of inter-sectoral and local inflation-related
problems. Some of these problems are results of the dominant part of the public sector.
Related functions
The RBI is also a banker tot the government and performs merchant banking function for the
central and the state government. It also acts as their banker. The National Housing Bank
(NHB) was established in 1988 to promote private real estate acquisition. The institution
maintains banking accounts of all scheduled banks, too. There is now an international
consensus about the need to focus the tasks of a central bank upon central banking. RBI is far
out of touch with such a principle, owing to the sprawling mandate described above. The
recent financial turmoil world-over, has however, vindicated the Reserve Bank's role in
maintaining financial stability in India.
CREDIT POLICY
Clear, written guidelines that set (1) the terms and conditions for supplying goods on credit,
(2) customer qualification criteria, (3) procedure for making collections, and (3) steps to be
taken in case of customer delinquency. Also called collection policy.
Guidelines that spell out how to decide which customers are sold on open account, the exact
payment terms, the limits set on outstanding balances and how to deal with delinquent
accounts.
THE POLICY changes in the banking system initiated by the RBI (Reserve Bank of India) in
its latest credit policy announcements all point to one fact: interest rates in the economy are
set to drop further. Last month, the RBI set the stage for another round of interest rate cuts by
reducing the Bank Rate–the rate at which banks borrow from the RBI–by half a percentage
point to 6.5 per cent and the cash reserve ratio (CRR)–the percentage of deposits banks have
to maintain with the RBI–by 2 percentage points to 5.5 per cent.
At a primary level, the two steps lower the cost of funds for banks and increase liquidity in
the system, respectively. At a secondary level, they have significant implications for your
personal finances.
Debt investments. Brace yourself for another round of cuts in interest rates on fixed-income
instruments like bank deposits, corporate bonds and deposits, and government securities.
Expect lower returns from new investments in these instruments. Although the inverse
relationship between interest rates and prices of fixed-income securities saw debt funds notch
up smart gains in their NAVs (net asset value) in the wake of the RBI move, this appreciation
is a one-off rise.
Loans. With the cost of funds coming down, lenders are likely to pass on the rate cuts to
customers. Banks are expected to take the lead. Housing finance companies, on the other
hand, will probably wait for NHB (National Housing Board) to drop refinance rates before
doing the same. The general expectation is of a cut of half a percentage point–the exact
amount will vary with the loan tenure. So, if you are planning to take a loan, wait for a
revision–credit is likely to come cheaper.
Equity investments. Softer interest rates will also improve the bottomlines of high-rated
companies who are in a position to negotiate better credit terms with lenders. Banks are the
biggest gainers from the RBI steps. The fall in CRR requirements means they can deploy
more funds at market rates. CRR investments currently earn 6.5 per cent interest (hiked from
6 per cent in this credit policy). Even if banks put this money in government securities, they
stand to earn an additional 2 percentage points. With yields on debt paper coming down,
banks will also see some appreciation in their investment portfolio. Even after factoring in the
lower lending rates, banks do gain at the net level.
As you create your policy, consider the link between credit and sales. Easy credit terms can
be an excellent way to boost sales, but they can also increase losses if customers default. A
typical credit policy will address the following points:
• Credit limits. You'll establish dollar figures for the amount of credit you're willing to
extend and define the parameters or circumstances.
• Credit terms. If you agree to bill a customer, you need to decide when the payment
will be due. Your terms may also include early-payment discounts and late-payment
penalties.
• Deposits. You may require customers to pay a portion of the amount due in advance.
• Credit cards and personal checks. Your bank is a good resource for credit card
merchant status and for setting policies regarding the acceptance of personal checks.
• Customer information. This section should outline what you want to know about a
customer before making a credit decision. Typical points include years in business,
length of time at present location, financial data, credit rating with other vendors and
credit reporting agencies, information about the individual principals of the company,
and how much they expect to purchase from you.
• Documentation. This includes credit applications, sales agreements, contracts,
purchase orders, bills of lading, delivery receipts, invoices, correspondence, and so
on.
• During 1st half of 2009-10, planned Open market operation purchases and MSS
unwinding to add primary liquidity of about Rs1,20,000Cr which, by way of monetary
impact, is equivalent to CRR reduction of 3.0%. This would leave adequate resources with
banks to expand credit.
Amid the current global financial market turmoil, the RBI will continue with the current
policy and procedures governing the presence of foreign banks in India. The RBI has decided
not to allow entry of new foreign banks into the country or allow foreign banks to acquire
stake in private banks. The proposed review will be taken up after due consultation once there
is greater clarity regarding stability and recovery of the global financial system.
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Global Economy
2. The global economy is showing increasing signs of stabilisation. The growth outlook in
virtually all economies is being revised upwards steadily, with the Asian region experiencing
a relatively stronger rebound. Global trade is gradually picking up, but other indicators of
economic activity, particularly capital flows and asset and commodity prices are more
buoyant. However, even as most of the forecasts on recovery are generally optimistic,
significant risks remain. The recovery in many economies is driven largely by government
spending, with the private sector yet to begin playing a significant part. There are signs that
high levels of global liquidity are contributing to rising asset prices as well as rising
commodity prices. Emerging market economies (EMEs) are generally recovering faster than
advanced economies. But they are also likely to face increased inflationary pressures due to
easy liquidity conditions resulting from large capital inflows.
3. While conditions in the beginning of 2010 are significantly better than they were at the
beginning of 2009, a different set of policy challenges has emerged for both advanced
economies and EMEs. In 2009, while advanced economies were focused on dealing with the
financial crisis, especially reviving the credit market and restoring the health of the financial
sector, EMEs were engaged in mitigating the adverse impact of the global financial crisis on
their real economies. In 2010, the effort in advanced economies will be to further improve the
financing conditions and strengthen the growth impulses, while the endeavour in the EMEs
will be to strengthen the recovery process without compromising on price stability and to
contain asset price inflation stemming from large capital inflows.
Domestic Economy
4. As stated in the Second Quarter Review of October 2009, India’s macroeconomic context
is different from that of advanced and other EMEs in at least four respects. One, India is
facing rising inflationary pressures, albeit largely due to supply side factors. Two,
households, firms and financial institutions in India continue to have strong balance sheets,
although there is a need to encourage domestic consumption and investment demand. Three,
since the Indian economy is supply-constrained, pick-up in demand could exacerbate
inflationary pressures. Four, India is one of the few large EMEs with twin deficits – fiscal
deficit and current account deficit.
5. Growth during Q2 of 2009-10, at 7.9 per cent, reveals a degree of resilience that surprised
many. Subsequent data releases, whether on industrial production, infrastructure or exports,
confirm the assessment that the economy is steadily gaining momentum. Based on this better-
than-expected performance, growth forecasts for 2009-10 have generally been revised
upwards. As reassuring as this recovery is, it is still unbalanced. Public expenditure continues
to play a dominant role and performance across sectors is uneven, suggesting that recovery is
yet to become sufficiently broad-based.
6. For several months, rapidly rising food inflation has been a cause for concern. More
recently, there are indications that the sustained increase in food prices is beginning to spill
over into other commodities and services as well. The increases in the prices of manufactured
goods have accelerated over the past two months. While food products, understandably,
contribute significantly to this, pressures in other sectors are also visible. Further, prices of
non-administered fuel items have increased significantly in line with rising international
prices. With growth accelerating in the second half of 2009-10 and expected to gain
momentum over the next year, capacity constraints could potentially reinforce supply-side
inflationary pressures.
7. The inflation risk looms larger when viewed in the context of global price movements. As
already indicated, global commodity prices are showing signs of firming up, driven both by
the recovery in demand and the asset motive. Significantly, prices of important food items are
also firming up. Going by the Food and Agriculture Organisation (FAO) data, the global rates
of increase in the prices of sugar, cereals and edible oils are now appreciably higher than
domestic rates. The opportunity to use imports as a way to contain domestic food prices is,
therefore, quite limited.
8. Monetary aggregates during 2009-10 have so far moved broadly in line with their
projections. However, non-food bank credit growth decelerated significantly from its peak of
over 29 per cent in October 2008 to a little over 10 per cent in October 2009. Thereafter, it
recovered to over 14 per cent by mid-January 2010. This credit performance should be seen
in the context of improved access of corporates to non-bank sources of funds this year. Rough
calculations show that the total flow of financial resources from banks, domestic non-bank
and external sources to the commercial sector during 2009-10 (up to January 15, 2010) at
Rs.5,89,000 crore was only marginally lower than Rs.5,95,000 crore in the corresponding
period of the previous year. These numbers suggest that non-bank sources of finance have, to
a large extent, mitigated the impact of the slow down in bank credit growth.
9. Our previous Reviews have commented on the monetary transmission during the crisis
period. While the changes in the Reserve Bank’s policy rates were quickly transmitted to the
money and government securities markets, transmission to the credit market was slower.
Evidently, the transmission is still in progress. The effective average lending rate of
scheduled commercial banks declined from 12.3 per cent in March 2008 to 11.1 per cent in
March 2009. Although relevant information for the subsequent period is not available, the
effective average lending rates may have declined further as banks’ benchmark prime lending
rates (BPLRs) softened by 25-100 basis points during this period.
10. Financial markets have remained orderly. Overnight money market rates remained below
or close to the lower bound of the liquidity adjustment facility (LAF) corridor. Liquidity
conditions remained comfortable with the Reserve Bank absorbing about Rs.1,09,000 crore
on a daily average basis during the current financial year. Yields on government securities
could potentially have increased sharply because of the abrupt increase in government
borrowings. However, the upward pressure on yields was contained by lower commercial
credit demand, open market operation (OMO) purchases and active liquidity management by
the Reserve Bank. Equity markets are behaving in a manner consistent with global patterns.
Real estate prices have firmed up as has been the trend in several other EMEs. Increasing
optimism about the recovery and high levels of liquidity are driving up real estate prices
although they are still some distance away from the pre-crisis peaks.
11. On the fiscal front, the stimulus by the government in the second half of 2008-09 has
clearly contributed significantly to the recovery. It may be recalled that the crisis-driven
stimulus by way of reduction in excise levies, interest rate subventions and additional capital
expenditure came on top of structural measures already built into the budget such as the Sixth
Pay Commission Award and farm debt waiver.
12. We will have to await the forthcoming budget in end-February 2010 for the
Government’s decision on phasing out the transitory components of the stimulus. As regards
the structural components, even though they were one-off, some of their impact is expected to
continue over the next couple of years, as state governments and public sector enterprises
align their compensation structures with the recommendations of the Sixth Pay Commission.
13. Managing the government borrowing programme to finance the large fiscal deficit posed
a major challenge for the Reserve Bank. In order to address this, the Reserve Bank front-
loaded the government borrowing programme, unwound MSS securities and undertook OMO
purchases.
14. On the external front, exports have begun responding to the revival in global demand.
Right through the difficulties of 2008-09 and the early months of the current financial year,
there was never any pressure on the current account. However, capital outflows in the third
quarter of 2008-09 led to some stress on the balance of payments, but we rode this out on the
strength of our forex reserves. The Reserve Bank, however, had to initiate some conventional
and non-conventional measures to ease the pressure on forex and rupee liquidity. In the space
of a year, the situation has clearly stabilised.
15. The current account deficit during April-September 2009 was US$ 18.6 billion, up from
US$ 15.8 billion during April-September 2008. Over the first half of 2009-10, capital inflows
resumed, but were not significantly in excess of the current account deficit. India’s improving
growth prospects, combined with persistently high levels of global liquidity, may result in a
significant increase in net inflows over the coming months. Depending on how these are
handled, there will be implications in terms of a combination of exchange rate appreciation,
larger systemic liquidity and the fiscal costs of sterilisation.
Global Outlook
Global Growth
16. Global economic performance improved during the third and fourth quarters of 2009,
prompting the IMF to reduce the projected rate of economic contraction in 2009 from 1.1 per
cent made in October 2009 to 0.8 per cent in its latest World Economic Outlook (WEO)
Update released on January 26, 2010. The IMF has also revised the projection of global
growth for 2010 to 3.9 per cent, up from 3.1 per cent (Table 1). The IMF expects the growth
performance, which will be led by major Asian economies, to vary considerably across
countries and regions, reflecting different initial conditions, external shocks, and policy
responses.
17. The IMF has also revised upwards its projection of the real GDP growth of emerging and
developing economies for 2009 to 2.1 per cent from its earlier number of 1.7 per cent. The
estimates are even more optimistic for 2010. The growth of emerging and developing
economies is now projected at 6.0 per cent, up from 5.1 per cent earlier. The growth in EMEs
such as China and India and other emerging Asian economies is expected to be robust.
Commodity-producing countries are likely to recover quickly in 2010 on the back of a
rebound in commodity prices.
Global Inflation
18. The IMF expects that the high levels of slack in resource utilisation and stable inflation
expectations will contain global inflationary pressures in 2010. In the advanced economies,
headline inflation is expected to increase from zero in 2009 to 1.3 per cent in 2010, as rising
energy prices may more than offset deceleration in wage levels. In emerging and developing
economies, inflation is expected to rise to 6.2 per cent in 2010 from 5.2 per cent in 2009 due
to low slack in resource utilisation and increased capital inflows.
Domestic Outlook
Growth
19. During 2009-10, real GDP growth accelerated from 6.1 per cent in Q1 to 7.9 per cent in
Q2 driven by revival in industrial growth, and pick-up in services sector growth, aided by
payment of arrears arising out of the Sixth Pay Commission Award. It is expected that Q3
growth, which will reflect the full impact of the deficient south-west monsoon rainfall on
kharif crops, would be lower than that of Q2. As rabi prospects appear to be better, on the
whole, agricultural GDP growth in 2009-10 is expected to be near zero.
20. As a result of the improvement in the global economic situation since the Second Quarter
Review in October 2009, exports expanded in November 2009, after contracting for 13
straight months. This positive trend is expected to persist. The industrial sector recovery,
some signs of which were noted in the Second Quarter Review, is now consolidating. The
performance of the corporate sector has picked up. Increased business optimism also reflects
brighter prospects for the industrial sector. Services sector activities have improved.
Domestic and international financing conditions have eased considerably, and this too should
support domestic demand.
21. In the Second Quarter Review of October 2009, we had placed the baseline projection for
GDP growth for 2009-10 at 6.0 per cent with an upside bias. The movements in the latest
indicators of real sector activity indicate that the upside bias has materialised. Assuming a
near zero growth in agricultural production and continued recovery in industrial production
and services sector activity, the baseline projection for GDP growth for 2009-10 is now
raised to 7.5 per cent (Chart 1).
22. Looking ahead to 2010-11, our preliminary assessment of the baseline scenario is that the
current growth will be sustained. This is a tentative assessment. We shall formally indicate
our growth projection for 2010-11 in our Monetary Policy in April 2010.
Inflation
23. Headline wholesale price index (WPI) inflation was 1.2 per cent in March 2009. It
continued to decline and became negative during June-August 2009 due to the large
statistical base effect. It turned positive in September 2009, accelerated to 4.8 per cent in
November 2009 and further to 7.3 per cent in December 2009. On a financial year basis,
between April-December 2009, WPI moved up by 8 per cent.
24. The deficient monsoon rainfall and drought conditions in several parts of the country
have accentuated the pressure on food prices, pushing up the overall inflation rate – both of
the WPI and consumer price indices (CPIs). Going forward, the rabi crop prospects are
assessed to be better. The large stock of foodgrains with public agencies should help supply
management. On the other hand, there is a risk that inflationary pressures may emanate from
the rebound in global commodity prices.
25. Assessment of inflationary pressures has become increasingly complex in the recent
period as the WPI and CPI inflation rates have shown significant divergence. All the four
CPIs have remained elevated since March 2008 due to the sharp increase in essential
commodity prices. The Reserve Bank monitors an array of measures of inflation, both overall
and disaggregated components, in conjunction with other economic and financial indicators
to assess the underlying inflationary pressures for formulating its monetary policy stance.
26. The Second Quarter Review of October 2009 projected WPI inflation of 6.5 per cent with
an upside bias for end-March 2010. The upside risks in terms of higher food prices reflecting
poor monsoon have clearly materialised. However, some additional factors have also exerted
upward pressure on WPI inflation. One, the expected seasonal moderation has not taken
place, other than in vegetables. Two, prices of the non-administered component of the fuel
group, tracking the movement in global crude prices, have also risen significantly. Three,
there have also been some signs of demand side pressures. The Reserve Bank’s quarterly
inflation expectations survey for households indicates that inflation expectations are on the
rise. Keeping in view the global trend in commodity prices and the domestic demand-supply
balance, the baseline projection for WPI inflation for end-March 2010 is now raised to 8.5
per cent (Chart 2).
27. As with growth, we shall formally announce our inflation projection for 2010-11 in our
Monetary Policy in April 2010. However, on the assumption of a normal monsoon and global
oil prices remaining around the current level, it is expected that inflation will moderate from
July 2010. This moderation in inflation will depend upon several factors, including the
measures taken and to be taken by the Reserve Bank as a part of the normalisation process.
28. As always, the Reserve Bank will endeavour to ensure price stability and anchor inflation
expectations. The conduct of monetary policy will continue to condition and contain
perception of inflation in the range of 4.0-4.5 per cent. This will be in line with the medium-
term objective of 3.0 per cent inflation consistent with India’s broader integration with the
global economy.
29. During the current financial year, the year-on-year growth in money supply (M3)
moderated from over 20.0 per cent at the beginning of the financial year to 16.5 per cent on
January 15, 2010, reflecting deceleration in bank credit growth during 2009-10. Year-on-year
increase in non-food bank credit to the commercial sector, at 14.4 per cent as on January 15,
2010, was significantly lower than the 22.0 per cent growth a year ago. Consequently, the
more important source of M3 expansion this year has been bank credit to the government,
reflecting the enlarged support to the market borrowing of the government and unwinding of
MSS securities.
30. Aided by the measures initiated by the Reserve Bank (see para 13), over 98 per cent of
the net market borrowing programme of the Central Government for 2009-10 has already
been completed by January 28, 2010. The anticipated increase in credit demand by the
commercial sector in the remaining period of 2009-10 can, therefore, be easily met from the
market as adequate liquidity is available in the system. In view of the increased availability of
funds from domestic non-bank and external sources (see para 8), the 18 per cent growth in
adjusted non-food credit growth projected earlier is unlikely to be realised. Accordingly, the
indicative adjusted non-food credit growth projection for 2009-10 is now reduced to 16 per
cent. Based on this projected credit growth and the remaining very marginal market
borrowing of the government, the projected M3 growth in 2009-10 has been reduced to 16.5
per cent for policy purposes. Consistent with this, aggregate deposits of scheduled
commercial banks are projected to grow by 17 per cent. These numbers, as before, are
provided as indicative projections and not as targets.
Risk Factors
31. While the baseline scenario is comforting, a number of downside risks to growth and
upside risks to inflation need to be recognised.
(i) There is still uncertainty about the pace and shape of global recovery. There are concerns
that it is too dependent on public spending and will unravel if governments around the world
withdraw their fiscal stimuli prematurely. As the world discovered during the recent crisis,
the global economy is heavily inter-linked through the business cycle. A downturn in global
sentiment will affect not only our external sector but also our domestic investment.
(ii) Oil prices have been range-bound in the recent period. However, if the global recovery
turns out to be stronger than expected, oil prices may increase sharply, driven both by
prospects of demand recovery and the return of the investment motive, which will affect all
commodities. This could stoke inflationary pressures even as growth remains below potential.
(iii) Expectations of softening domestic inflation are contingent on food prices moderating.
This, in turn, depends significantly on the performance of the south-west monsoon in 2010. If
rainfall is inadequate, high food prices will continue to intensify inflationary pressures.
(iv) So far, capital inflows have been absorbed by the current account deficit. However, sharp
increase in capital inflows, above the absorptive capacity of the economy, may complicate
exchange rate and monetary management.
(v) As growth accelerates and the output gap closes, excess liquidity, if allowed to persist,
may exacerbate inflation expectations.
32. Beyond the above risk factors, by far a bigger risk to both short-term economic
management and to medium-term economic prospects emanates from the large fiscal deficit.
The counter-cyclical public finance measures taken by the government as part of the crisis
management were necessary; indeed they were critical to maintaining demand when other
drivers of demand had weakened. But as the recovery gains momentum, it is important that
there is co-ordination in the fiscal and monetary exits. The reversal of monetary
accommodation cannot be effective unless there is also a roll back of government borrowing.
As indicated earlier (para 13), even as the government borrowing had increased abruptly
during 2008-09 and 2009-10, it could be managed through a host of measures that bolstered
liquidity. Those liquidity infusion options will not be available to the same extent next year.
On top of that, there will be additional constraints. Inflation pressures will remain and private
credit demand will be stronger with the threat of crowding out becoming quite real.
33. There are standard, well-known and well-founded reasons for fiscal consolidation. For
both short-term economic management and medium-term fiscal sustainability reasons, it is
imperative, therefore, that the government returns to a path of fiscal consolidation. The
consolidation can begin with a phased roll back of the transitory components. Beyond that, in
the interest of transparency and predictability, the government should ideally do two things:
first, indicate a roadmap for fiscal consolidation; and second, spell out the broad contours of
tax policies and expenditure compression that will define this roadmap.
34. The Reserve Bank has pursued an accommodative monetary policy beginning mid-
September 2008 in order to mitigate the adverse impact of the global financial crisis on the
Indian economy. The measures taken instilled confidence in market participants and helped
cushion the spillover of the global financial crisis on to our economy. However, in view of
rising food inflation and the risk of it impinging on inflationary expectations, the Reserve
Bank announced the first phase of exit from the expansionary monetary policy by terminating
some sector-specific facilities and restoring the statutory liquidity ratio (SLR) of scheduled
commercial banks to its pre-crisis level in the Second Quarter Review of October 2009.
35. Against the above backdrop of global and domestic macroeconomic conditions, outlook
and risks, our policy stance in this Quarter is shaped by three important considerations:
(i) A consolidating recovery should encourage us to clearly and explicitly shift our stance
from ‘managing the crisis’ to ‘managing the recovery’. We articulated this change in our
stance in the October quarterly review, but the growing confidence in the recovery justifies
our moving further in reversing the crisis-driven expansionary stance. Our main policy
instruments are all currently at levels that are more consistent with a crisis situation than with
a fast-recovering economy. It is, therefore, necessary to carry forward the process of exit
further.
(ii) Though the inflationary pressures in the domestic economy stem predominantly from the
supply side, the consolidating recovery increases the risks of these pressures spilling over into
a wider inflationary process. Looking ahead into 2010-11, if the growth momentum turns out
to be as expected, pressures on capacities in an increasing number of sectors are likely to
strengthen the transmission of higher input and wage costs into product prices.
(iii) Even amidst concerns about rising inflation, we must remember that the recovery is yet
to fully take hold. Strong anti-inflationary measures, while addressing one problem, may
precipitate another by undermining the recovery, particularly by deterring private investment
and consumer spending.
36. Against this backdrop, the stance of monetary policy of the Reserve Bank for the
remaining period of 2009-10 will be as follows:
• Anchor inflation expectations and keep a vigil on the trends in inflation and be prepared to
respond swiftly and effectively through policy adjustments as warranted.
• Actively manage liquidity to ensure that credit demands of productive sectors are adequately
met consistent with price stability.
• Maintain an interest rate environment consistent with price stability and financial stability,
and in support of the growth process.
37. On the basis of the current assessment and in line with the policy stance as outlined in
Section III, the Reserve Bank announces the following policy measures:
Bank Rate
38. The Bank Rate has been retained at 6.0 per cent.
Repo Rate
39. The repo rate under the Liquidity Adjustment Facility (LAF) has been retained at 4.75 per
cent.
Reverse Repo Rate
40. The reverse repo rate under the LAF has been retained at 3.25 per cent.
• increase the cash reserve ratio (CRR) of scheduled banks by 75 basis points from 5.0 per cent
to 5.75 per cent of their net demand and time liabilities (NDTL) in two stages; the first stage
of increase of 50 basis points will be effective the fortnight beginning February 13, 2010,
followed by the next stage of increase of 25 basis points effective the fortnight beginning
February 27, 2010.
42. As a result of the increase in the CRR, about Rs. 36,000 crore of excess liquidity will be
absorbed from the system.
43. The Reserve Bank will continue to monitor macroeconomic conditions, particularly the
price situation closely and take further action as warranted.
Expected Outcomes
(ii) The recovery process will be supported without compromising price stability.
(iii) The calibrated exit will align policy instruments with the current and evolving state of
the economy.