Third Bi-monthly Policy Statement
On the basis of an
assessment of the current and evolving macroeconomic situation, it has been
decided to:
• keep the policy repo rate
under the liquidity adjustment facility (LAF) unchanged at 7.25 per cent;
• keep the cash reserve
ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time
liability (NDTL);
• continue to provide
liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the LAF
repo rate and liquidity under 14-day term repos as well as longer term repos of
up to 0.75 per cent of NDTL of the banking system through auctions; and
• continue with daily
variable rate repos and reverse repos to smooth liquidity.
Consequently, the reverse
repo rate under the LAF will remain unchanged at 6.25 per cent, and the
marginal standing facility (MSF) rate and the Bank Rate at 8.25 per cent
Assessment
2. Since last statement,
global economic activity has recovered modestly in Q2 of calendar 2015. The US
economy rebounded on stronger consumption growth and steadily improving labour
market conditions, though recent wage data suggest continuing slack. The Euro
area has grown at a moderate pace through the first half of 2015, supported by
consumer spending, easing financing conditions and a modest downturn in
still-high unemployment. In Japan, growth slowed in Q2 after an upside surprise
in Q1. Domestic consumption is still weak, but manufacturing activity picked up
in July and strengthening exports and corporate profitability could stimulate
capital spending in H2. In the emerging market economies (EMEs), activity
decelerated through H1 due to headwinds from weak external demand, tightening
external financing conditions, deteriorating structural bottlenecks and spill
overs from unsettled conditions in financial markets. Despite aggressive policy
stimuli, the Chinese economy is slowing on macroeconomic rebalancing, sizable
stock market corrections, a cooling property market and excess capacity in
several manufacturing industries. Manufacturing activity weakened further in
July, clouding near-term expectations. Recessionary conditions persist in both
Russia and Brazil, with downside risks from commodity prices and geopolitical
developments casting a shadow on the outlook, including for other EMEs.
3. In recent months,
financial markets have experienced high turbulence due to the Greek crisis, the
Chinese stock market slump and shifts between risk-on and risk-off sentiments
based on changes in beliefs about when the Federal Reserve will start raising
rates. Bond market sell-offs originating in Germany lifted bond yields across
the world, including in EMEs, and tightened financing conditions. Equity
markets were buoyed by the search for yields which stretched asset valuations
until end-June, when sharp stock market corrections in China pulled down share
prices globally. Currency markets were dominated by the rising US dollar, which
impacted foreign currency borrowing exposures, increased exchange rate
volatility and also produced sizable capital outflows from EMEs. Investors have
reduced exposures to EMEs as an asset class, but a generalised flight to safety
is yet to be seen. Investors have also shunned commodities affected by the
Chinese slowdown, including bullion.
4. In India, the economic
recovery is still work in progress. After strong rainfall in June, July has
been below par, but on net, the monsoon is near normal. Higher reservoir levels
also auger well for the prospects of kharif output, particularly for areas that
are dependent on irrigation. Consequently, kharif sowing has expanded
significantly relative to a year ago, especially in respect of oilseeds,
pulses, rice and coarse cereals. These developments, supported by contingency
plans for vulnerable districts, provide cushion against adverse weather shocks.
If prospects of a good harvest strengthen, currently weak rural demand will
improve to provide an important boost to activity. Shrinking exports in some
industries, in part a result of weak global demand and global overcapacity in
those industries and in part a result of the significant depreciation of
currencies of some major trading partners against the rupee, also contributed to
weak aggregate demand. The Reserve Bank’s survey-based indicators point to flat
capacity utilisation and new orders, with corporate sales growth declining –
although lower inflation explains some of the compression in top lines.
Although overall business confidence is positive, the level of optimism was a
shade lower in April-June than in the preceding quarter. Investment, as
measured by new projects, is still weak, primarily because of still-low
capacity utilization. In the critically important power sector, where final
demand is strong, the recent step-up in generation in response to the
commendable easing of bottlenecks in coal supply is being partly negated by
structural problems relating to clogging of transmission grids and the dire
financial state of electricity distribution companies (DISCOMs).
5. However, there are signs
that consumption demand, especially in urban areas, is picking up. Car sales
for July were strong. Nominal bank credit growth is lower than previous years,
but adjusted for lower inflation as well as for lower borrowing by oil
marketing companies and increased borrowing from commercial paper markets,
credit availability seems to be adequate for most sectors.
6. The services sector
continues to emit mixed signals. The pick-up in heavy commercial vehicle sales
and rising port and domestic air freight in Q1 suggest strengthening
transportation activity (for Indian data, Q refers to fiscal year quarters).
Purchasing managers’ indices were in contraction zone in June, mainly due to
lower new and existing business conditions. Survey-based expectations of the
outlook for the services sector point to positive sentiment in Q2 on the back
of an expected increase in turnover and profit margin.
7. Headline consumer price
index (CPI) inflation rose for the second successive month in June 2015 to a
nine-month high on the back of a broad based increase in upside pressures,
belying consensus expectations. The sharp month-on-month increase in food and
non-food items overwhelmed the sizable ‘base effect’ in that month. Food
inflation rose 60 basis points over the preceding month, driven by a spike in
prices of vegetables, protein items - especially pulses, meat and milk - and
spices.
8. Furthermore, excluding
food and fuel, inflation rose in respect of all sub-groups other than housing.
The momentum of price increases remained high for education. Inflation
pressures increased for personal care and effects and household goods and
services sub-groups. Inflation in CPI excluding food, fuel, petrol and diesel has
been rising steadily since April and exceeded headline inflation through Q1.
Near-term inflation expectations of households returned to double digits after
two quarters, although those of professional forecasters remained anchored.
Rural wage growth was moderate but there are indications of incipient pressures
from corporate staff costs.
9. Liquidity conditions
have been very easy in June and July. A seasonal reduction in demand for
currency and increased spending by Government coupled with structural factors
such as low credit deployment relative to the volume of deposit mobilisation
contributed to surplus conditions in the money markets. This resulted in a
significantly lower average daily net liquidity injection under the fixed rate
repos under LAF, and variable rate term repo/reverse repo and MSF at 477
billion in June, down from 1031 billion in May. In July there was net
absorption of 120 billion through these facilities. In response to the
reduction in the policy repo rate in June the weighted average call rate eased
from 7.47 per cent in May to 7.11 per cent in June. The Reserve Bank also
conducted open market sales worth 83 billion in the second week of July,
essentially in response to lack of demand for longer duration reverse repos.
The call money rate remained below the repo rate through July, reflecting
comfortable liquidity conditions.
10. Headwinds from weak
global demand conditions restrained merchandise exports. The contraction in
exports in Q1 of 2015-16, both volume and value, was the steepest since Q2 of
2009-10. The sharp fall in international commodity prices - especially crude
oil - compressed import payments, helping to narrow the trade deficit. Domestic
production shortages and lower international prices were, however, evident in
higher imports of electronic goods, pulses, iron ore and fertilisers. Net
surpluses on account of trade in services were sustained in Q1 and have, along
with the lower trade deficit, helped reduce the current account deficit (CAD).
Despite slowing portfolio flows, other forms of foreign capital flows such as
foreign direct investment and non-resident deposits were sustained. With the
shrinking external financing requirement, reserves were built up to an all-time
high at the end of June, providing a buffer against adverse global shocks.
Policy Stance and Rationale
11. The bi-monthly policy
statements of April and June indicated that the accommodative stance of
monetary policy will be maintained going forward, but monetary policy actions
will be conditioned by (a) fuller transmission by banks of the Reserve Bank’s
front-loaded rate reductions into their lending rates; (b) developments in food
prices and their management, especially the effects of the monsoon, while
looking through both seasonal as well as base effects; (c) a continuation and
even acceleration of policy efforts to unclog the supply side so as to make
available key inputs such as power and land, as also repurposing of public
spending from poorly targeted subsidies towards public investment and reducing
the pipeline of stalled investment; and (d) signs of normalisation of the US
monetary policy. In the June statement, it was pointed out that a targeted
infusion of bank capital is also warranted so that adequate credit flows to the
productive sectors as investment picks up.
12. Since the first rate
cut in January, the median base lending rates of banks has fallen by around 30
basis points, a fraction of the 75 basis points in rate cut so far. As loan
demand picks up in Q3 of 2015-16, banks will see more gains from cutting rates
to secure new lending, and
more transmission will take place. The welcome announcement by Government of
infusion of bank capital into public sector banks will help loan growth and
hence transmission, as will currently easy liquidity conditions.
13. During 2015-16 so far,
inflation conditions have evolved around the path projected in April and June
bi-monthly policy statements, though they surprised somewhat on the upside in
June. Large base effects, which the Reserve Bank will look through, are
expected to pull down headline inflation in July and August. From September,
favourable base effects wane.
14. Turning to the balance
of inflation risks, most worrisome is the sustained hardening of inflation
excluding food and fuel. Moreover, the full effects of the service tax
increase, which took effect from June, will feed through over the rest of the
year. Some food prices, particularly of protein-rich items, pulses and oilseeds
have risen sharply in recent months. They will have to be carefully monitored
as they tend to be sticky and impart an upward bias to inflation and inflation
expectations. This assumes significance in view of households’ inflation
expectations rising again. Several factors, however, could have a significant
mitigating influence. These include the sharp fall in crude prices since June
and the likelihood of this softness persisting in view of the global supply
glut and expanding production by Iran; the welcome increase in planting of
pulses and oilseeds and prospects of rainfall in August and September according
to some forecasters; the effects of the Government’s current pro-active supply
management to contain shocks to food prices, especially of vegetables,
alongside its decision to keep increases in minimum support prices moderate.
15. Relative to the
projections of the second bi-monthly statement, inflation projections in this
bi-monthly statement are elevated by the higher than expected June observation
but reduced by prospects of softer crude prices and a near-normal monsoon thus
far. This implies that inflation projections for January-March 2016 are lower
by about 0.2 per cent, with risks broadly balanced around the target of 6.0 per
cent for January 2016 (Chart 1).
16. Taking into account all
this, and given that policy action was front-loaded in June, it is prudent to
keep the policy rate unchanged at the current juncture while maintaining the
accommodative stance of monetary policy. Short term real risk free rates are
nevertheless supportive of borrowing by interest rate sensitive consumer
segments such as housing and automobiles. Significant uncertainty will be
resolved in the coming months, including the likely persistence of recent
inflationary pressures, the full monsoon outturn, as well as possible Federal
Reserve actions. As the Reserve Bank awaits greater transmission of its
front-loaded past actions, it will monitor developments for emerging room for
more accommodation.
17. The outlook for growth
is improving gradually. Favourable real income effects could accrue from weaker
commodity prices, in particular crude oil, and a possible step-up in
agricultural activity if monsoon conditions continue to improve. On the other
hand, global growth projections for 2015 have generally been revised downwards
and, therefore, the export contraction could become a prolonged drag on growth
going forward. Notwithstanding some improvement in the state of stalled
projects, supply constraints continue to be binding and new investment demand
emanating from the private sector and the central Government remains subdued.
On an assessment of the evolving balance of risks, the projected output growth
for 2015-16 has been retained at 7.6 per cent (Chart 2).
18. The fourth bi-monthly
monetary policy statement will be announced on September 29, 2015.
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