Annual Report

I.2.39 The rate of Gross Domestic Capital Formation (GDCF) increased from 24.8 per cent in 2002-03 to 26.3 per cent in 2003-04 due to increases in both public and private corporate investments (Table 1.14).

I.2.40 Preliminary estimates, based on the latest available information, place the rate of financial saving (net) of the household sector in 2004-05 at 9.9 per cent of GDP at current market prices as compared with the revised estimates of 11.4 per cent in 2003-04 (Table 1.15 and Appendix Table I.14). Increases in the rate of saving in the form of claims on Government (particularly, small savings) and investment in shares and debentures were more than offset by decline in saving in the form of currency, deposits and contractual saving. Financial liabilities of the household sector registered a sharp increase due to higher loans and advances principally driven by personal loans to finance consumer durables and increased demand for housing loans.

I.3.1 The evolution of monetary conditions during 2004-05 reflected the impact of a number of developments. First, capital flows continued to be strong, despite a lull during May-October, 2004 and liquidity conditions, given the overhang of over Rs.81,000 crore at the beginning of the year, remained easy. With the persistence of capital flows, the Reserve Bank continued with sterilisation operations through the Liquidity Adjustment Facility (LAF) and the newly-introduced Market Stabilisation Scheme (MSS), which contained money supply within the indicative projection set in May, 2004. Second, there was a robust expansion in credit demand which firmed up since July 2004. Third, the surge in banks’ non-food credit operations was accommodated by a reduction in the Government’s borrowing programme. Four th, movements in inflation driven by international commodity prices engaged policy attention as an overriding priority. In order to rein in inflation, fiscal measures were initiated to contain the pass-through of the increases in international oil and non-oil commodity prices to domestic inflation, in conjunction with monetary policy actions to modulate monetary and liquidity conditions and prudent supply management. These calibrated policy responses were able to return inflation from a spike in end-August 2004 to 5.1 per cent by the year end, consistent with the projection made in the May 2004 Annual Policy Statement.

I.3.2 Reserve money growth decelerated to 12.1 per cent during 2004-05 from 18.3 per cent during 2003-04 (Appendix Tables I.15 and I.16). Even as capital flows remained sizeable, base money expansion could be

contained due to greater manoeuvrability provided by the operationalisation of the MSS. The slower growth of reserve money in 2004-05 also reflected the base effect of the excess reserves built up on March 31, 2004 partly counterbalanced by the 50 basis points increase in the cash reserve ratio (CRR) in two stages during September-October 2004, which impounded around Rs.9,000 crore in the first round (Chart I.8). In addition, the remuneration on the banks’ eligible CRR balances was lowered from the Bank Rate (6.0 per cent) to 3.5 per cent.

I.3.3 Reserve money declined in the first quarter of the year mainly on account of MSS/LAF operations. Seasonal cash demand was largely funded by the draw down of the excess reserves built towards the end of 2003-04 (Rs.19,662 crore during March 26-31, 2004).

I.3.4 The monetary base continued to contract during the second quarter of 2004-05 as a result of capital outflows, along with an increase in the Government’s surplus cash balances with the Reserve Bank. A brief period of tight liquidity arising out of pressures from State Development Loans auctions, redemptions from mutual funds and the need to meet reserve requirements prompted the Reserve Bank to inject liquidity (Rs.5,000 crore) through the LAF on August 12, 2004. During the third quarter, the robust expansion in non-food credit off-take and a spurt in festival season currency demand exerted pressure on liquidity. Reserve money expanded sharply as the Reserve Bank injected daily net liquidity

of over Rs.10,000 crore, on an average, during November 5-22, 2004 through the LAF and again (around Rs.3,500 crore daily, on an average) during December 20-24, 2004. During the fourth quarter, liquidity conditions turned comfortable, facilitated by large capital inflows and a decline in the Centre’s cash balances with the Reserve Bank. Reserve money increased by over Rs.34,000 crore (Table 1.16).

I.3.5 Foreign currency assets (adjusted for revaluation) of the Reserve Bank increased by Rs.1,15,044 crore in 2004-05 on top of an accretion of Rs.1,41,428 crore in 2003-04, albeit with higher intra-year variability in 2004-05 (Chart I.9). As a result, the ratio of net foreign exchange assets (NFEA) to currency as well as to reserve money increased further during the year.

I.3.6 Consequent upon the operationalisation of the MSS in April 2004, the Reserve Bank’s net credit to the Government declined by Rs.62,882 crore during 2004-05 on top of a decline of Rs.75,772 crore in the previous year. This decline also reflected the improvement in the fiscal position of the Government. The Centre, which had resorted to ways and means advances (WMA) on several occasions till early September 2004, did not avail of WMA in the subsequent period. States’ recourse to WMA/overdrafts was also lower in 2004-05 than in the previous year. The Reserve Bank’s support to the Government in the primary market through private placement/devolvement was markedly lower (Table 1.17).

I.3.7 The substantial accretion to the Reserve Bank’s foreign currency assets was reflected in rising MSS balances with the Reser ve Bank.

In the context of the Reserve Bank’s function as banker to the Central Government, the Government parks its funds with the Reserve Bank, free of interest, under Sections 17(1) and 19(6) of the Reserve Bank of India Act, 1934. The Central Government and the Reserve Bank reached an agreement in 1997 under which the surplus funds of the Centre are invested in its own paper. This arrangement of buy-back of its own securities effectively enables the Central Government to obtain a notional return on such balances.

Surplus balances of the Government with the central bank have been effectively used as an instrument of sterilisation in many countries. The Government of Singapore, for example, issues Government securities in excess of the fiscal requirements and parks the surplus funds with the Monetary Authority of Singapore (MAS) as deposits, thus supplementing its draining operations. Countries such as, Malaysia, Thailand and Indonesia have regulated excess liquidity in the financial system by diver ting the Government/public sector deposits from the commercial banking system to the central bank.

In the Indian context, the Reserve Bank’s Working Group on Instruments on Sterilisation (Chairperson: Smt. Usha Thorat) observed that the cost of sterilisation is ultimately borne by the fisc. In the light of reduction in stock of the Government securities with the Reserve Bank, the Group was in favour of revisiting the 1997 agreement so that the Government’s surpluses with the Reserve Bank are not automatically invested and can remain as interest-free balances with the Reserve Bank, thereby, releasing Government securities for further sterilisation operations.

The Central Government has maintained sizeable sur plus balances in its current account with the Reserve Bank almost continuously since August 2003, enabled, inter alia, by substantial inflows under the debt swap scheme and increased issuance of Treasury Bills. In order to ensure a sizeable stock of Government paper with the Reserve Bank for its monetary policy operations, investment of the Central Government’s surplus cash balances in dated securities was discontinued temporarily from April 8, 2004. Subsequently, with the introduction of the MSS to absorb liquidity, investment of the Centre’s surplus balances in its own paper held by the Reserve Bank was partially restored with a ceiling of Rs.10,000 crore in June 2004 (enhanced to Rs.20,000 crore in October 2004).

1. Reserve Bank of India (2003), Report of the Working Group on the Instruments of Sterilisation (Chairperson : Smt. Usha Thorat).

A build-up of the gilt portfolio with the Reserve Bank as a result of the unwinding of LAF reverse repo balances was counterbalanced by accretions to the Centre’s cash balances, which, in turn, were invested in the Centre’s own paper held by the Reserve Bank (Box I.7).

I.3.8 The year-on-year reserve money expansion stood at 15.2 per cent as on August 12, 2005 –higher than that of 13.8 per cent recorded a year ago. Despite a somewhat lower order of accretion to the Reserve Bank’s NFA, the higher reserve money expansion largely reflected the effect of the 50 basis points increase in the CRR during September-October, 2004.

I.3.9 Broad money (M3) growth at 12.2 per cent during 2004-05 was lower than that of 16.7 per cent in the previous year and well within the projected trajectory of 14.0 per cent (Appendix Table I.17). The deceleration in M3 reflected, in part, the base effect of higher deposit mobilisation by commercial banks during the last quarter of the previous year (Chart I.10).

I.3.10 The moderation in monetary expansion visà-vis the preceding year was also reflected in the residency-based new monetary aggregate (NM3), (which excludes the impact of foreign currency non-resident deposits) as well as in the liquidity aggregates (Appendix Tables I.18 and I.19). Banks’ non-resident foreign currency deposits registered a modest increase during 2004-05 after the decline due to redemption of Resurgent India Bonds (RIBs) in 2003-04. Postal deposits maintained high growth. Deposit mobilisation by financial institutions (FIs), on the other hand, continued to dwindle, par tially reflecting conversion of a financial institution into a bank. Public deposits with NBFCs stagnated, due to a reduction in the number of deposit taking NBFCs coupled with a shift towards relatively cheaper non-deposit sources of funds like secured debentures and other corporate borrowings (Table 1.18).

I.3.11 Currency demand moderated during the second half of 2004-05 reflecting a slowdown in agricultural activity and base effects of high currency growth during the second half of the previous year (Chart I.11).

I.3.12 Banks’ deposit growth decelerated, partly reflecting substitution in favour of postal deposits to take advantage of the dual benefit of tax incentives and the relatively attractive rate of return in comparison with banks’ fixed deposits (Chart I.12).

I.3.13 The abundance of liquidity in the system and easier access to relatively low-cost international markets during the year provided commercial banks with the incentive to mobilise funds through the non-deposit route, both at home and abroad. Reflecting these alternative avenues, banks’ term money borrowings from non-bank entities increased from Rs.24,670 crore at end-March 2004 to Rs.34,348 crore at end-March 2005. Similarly, borrowings from international markets by commercial banks rose from Rs.17,137 crore at end-March 2004 to Rs.25,666 crore at end-March 2005.

I.3.14 Domestic bank credit growth (including banks’ non-SLR investments) accelerated to 12.9 per cent during 2004-05 from 10.8 per cent during the previous year. The share of the Government in total domestic credit fell sharply to 35.7 per cent by end-March 2005 from 40.2 per cent at end-March 2004.

I.3.15 Net bank credit to the Government increased by only 0.4 per cent during 2004-05 mainly due to a lower than budgeted borrowing programme of the Centre. The sustained decline in the Reserve Bank’s net credit to the Government pushed the share of the banks in net bank credit to the Government to 102.4 per cent at end-March 2005 from 94.0 per cent at end-March 2004 and 37.1 per cent at end-March 1990. Commercial banks’ appetite for Government paper was moderated by the upturn in the interest rate cycle. Growth in investments of scheduled commercial banks in Government paper, at 7.9 per cent during 2004-05, was the lowest since 1985-86. Notwithstanding this deceleration, commercial banks’ holdings of Government securities, at 38.5 per cent of their net demand and time liabilities (NDTL) at end-March 2005, remained far in excess of the prescribed statutory minimum ratio of 25 per cent. Since the proceeds of the paper issued under the MSS to the banking system are parked with the Reserve Bank, the resultant increase in commercial banks’ investments in Government paper is counterbalanced by a reduction in the Reserve Bank’s net credit to the Government. Thus, the MSS is neutral to the size of the net bank credit to the Government, although there is a corresponding rebalancing of the shares of the Reserve Bank and commercial banks.

I.3.16 A notewor thy feature of monetar y developments during the year was the acceleration in bank credit to the commercial sector. In contrast to the decline of the previous two years, food credit registered a turnaround due to higher procurement operations. The pick-up in commercial banks’ non-food credit, which took root in July 2004, was sustained by the continued buoyancy in the industrial sector. Credit off-take from commercial banks, in fact, outpaced growth in deposits with the incremental credit-deposit ratio jumping up to 118.1 per cent during 2004-05 from 49.9 per cent during 2003-04 (Appendix Table I.20). Commercial banks’ non-SLR investments also recorded an increase. Reflecting the improvement in equity prices, there were switches in the banks’ non-SLR portfolio in favour of equities from PSU bonds (Table 1.19).

I.3.17 In addition to the surge in bank credit, industry also increased its recourse to non-bank sources of funds. Resources raised by way of external commercial borrowings (ECBs) increased, reflecting higher demand as well as attractive cost of external financing. The robust performance of the capital market encouraged corporates to mobilise funds through primary issues. Financial assistance extended by financial institutions, however, continued to dwindle. Improved cor porate profitability led to higher retained earnings which emerged as another important source of funds for corporates during 2004-05 (Table 1.20).

I.3.18 Sectoral deployment of bank credit indicates that the priority sector continued to be the largest recipient of gross bank credit (Table 1.21). This was essentially on account of a substantially higher offtake by the ‘other priority’ segment, representing primarily small housing loans (loans up to Rs.15 lakh; Rs.10 lakh prior to September 2004). Large housing loans (above Rs.15 lakh) also maintained strong growth. Low interest rates and fiscal incentives have boosted the demand for housing loans (Appendix Table I.22).

I.3.19 Credit to medium and large industries registered a sharp expansion, led by an increase in credit to power, telecommunications, roads and ports, petroleum, gems and jewellery, drugs and pharmaceuticals, textiles, iron and steel and other metal and metal products. Infrastructure, as a sector, continued to lead the credit demand, accounting for 37 per cent of the industrial credit during the year. Credit to roads and ports and the telecommunication sector, in particular, recorded a sharp increase. Petroleum credit increased in contrast to the decline in 2003-04, reflecting the incomplete pass-through of the increase in international crude oil prices to prices of domestic finished petroleum products. The higher credit to the gems and jewellery sector was driven by strong export demand (Appendix Table I.23).

I.3.20 In brief, monetary and liquidity conditions remained easy even though there was a sharp pick-up in demand for bank credit during 2004-05. In order to finance this step-up in credit demand, banks significantly scaled down their incremental investments in Government securities during the year. Reserve money growth during 2004-05 was lower than 2003-04 and money supply growth remained within the indicative trajectory set out in the Annual Policy Statement in May 2004.

I.3.21 On a year-on-year basis, growth in broad money (M3) decelerated to 14.5 per cent on August 5,

2005 from 15.5 per cent a year earlier. The lower order of growth reflected mainly slower growth in time

^M3 deposits. Demand deposits, however, recorded strong growth, mirroring a sustained pick-up in banks’ non-food credit. The slowdown in net bank credit to the Government helped in accommodating the surge in commercial credit.

I.3.22 Liquidity in the banking system remained comfortable throughout 2004-05 (Appendix Table I.21). The first quarter began with a large liquidity overhang in the system. This was augmented by strong time deposit mobilisation by commercial banks, even adjusted for the year-end bulge of March 2004. Banks’ mobilisation of non-deposit funds in the form of call-term funding from FIs and overseas borrowings was also significant. The commencement of the Government’s market borrowing programme and the introduction of the MSS got reflected in a beginning-of-the-year surge in commercial banks’ investment in Government securities. Commercial credit growth was high in contrast to the seasonal slack at the beginning of the year. Food credit picked up, reflecting high rabi procurement (Table 1.22).

I.3.23 During the second quarter, time deposits went through a seasonal downturn. Bank credit started picking up despite repayments of food credit, reflecting the strong growth in commercial credit. This was funded in part by a reduction in banks’ gilt portfolio.

I.3.24 Deposits continued to grow in the third quarter, although much lower than in the comparable quarter of the previous year. Credit to the commercial sector remained robust. The increase in food credit reflected higher procurement during the kharif season. Banks’ investments in non-SLR securities expanded, reflecting a surge in their equity investments following the rally in the stock market. Commercial banks’ net foreign currency assets recorded a decline due to higher overseas foreign currency borrowings. Banks’ investments in Government securities declined in an environment of continued growth in non-food credit, occasional tightness in market liquidity owing to a hike in the CRR, a temporary slack in capital inflows, advance tax payments and festival season currency demand.

I.3.25 Both demand and time deposits recorded a seasonal spurt during the fourth quarter. Strong FII inflows added liquidity to the banking system. The spur t in conventional non-food credit was supplemented by large investments in non-SLR securities. The Reserve Bank’s sterilisation operations were reflected in an increase in commercial banks’ holding of Government securities.

I.3.26 Inflation firmed up worldwide during 2004 as higher input demand emanating from global growth and the sustained expansion of the Chinese economy pushed up oil and non-oil commodity prices. Hardening international commodity prices as well as domestic food prices responding to a deficient monsoon fuelled a spurt in inflation in India during the second quarter of 2004-05. Inflation began to ease from September 2004 under the impact of a mix of fiscal measures to moderate the pass-through of imported inflation, monetary policy measures to stabilise inflation expectations, the waning of the impact of the SouthWest monsoon on agricultural commodity prices and the base effect of the sharp increase in prices in the last quarter of the preceding year.

I.3.27 According to the International Monetary Fund’s World Economic Outlook, consumer price inflation in 2004 firmed up to 2.0 per cent in advanced economies after remaining below 2.0 per cent for two years in succession. Although inflation softened marginally in emerging market and developing countries to 5.7 per cent in 2004 from 6.0 per cent in the previous two years, developing Asia saw higher inflation at 4.2 per cent in 2004 (2.6 per cent in 2003), driven up by stronger economic activity and higher oil prices (Chart I.13).

I.3.28 Producer prices led consumer prices throughout the year. The increase in commodity prices was initially absorbed by firms in their profit margins, creating a wedge between producer and consumer prices in most economies. The persistence of increases in commodity prices and improvement in consumer demand generated some upward pressure on consumer prices. The possibility of easy monetary conditions fuelling asset prices and accommodating inflationary expectations led a number of central banks, including the US Federal Reserve,

to reverse their accommodative monetary policy stance through measured increases in policy rates (Table 1.23).

I.3.29 In the US, headline consumer price inflation accelerated during 2004, driven up by higher oil prices, a weakening of the US dollar and higher producer prices. In the Euro area, inflation, measured by the Harmonised Index of Consumer Prices (HICP), remained above the European Central Bank’s (ECB) target of about 2.0 per cent in the latter half of 2004, due to higher oil prices. In the UK, CPI inflation decreased marginally from 1.4 per cent in 2003 to 1.3 per cent in 2004 but picked up in the first half of 2005. Producer price inflation hardened in Japan fuelled by higher growth in the first half of the year and higher oil prices, pushing consumer price inflation into neutral and even positive territory in the last quarter of 2004. The continued expansion of the Chinese economy and the surge in oil costs drove producer prices in China to 5.2 per cent in June 2005. Consumer price inflation, however, decelerated to 1.6 per cent in June 2005 from 5.0 per cent a year ago due to a decline in foodgrains prices, limited pass-through of high oil prices as well as a moderation in monetary and credit expansion.

I.3.30 The international inflation scenario in 2004-05 was essentially dominated by the developments in the commodity markets, especially metals and crude oil (Chart I.14). Although the upsurge in the last quarter of 2003 continued up to the first half of 2004, non-oil commodity prices stabilised over the rest of 2004 at elevated levels. Due to the depreciation of the US dollar against major currencies, the increase in commodity prices in the international markets in US dollar terms was higher than in terms of the Euro or the Japanese Yen.

I.3.31 Prices of agricultural commodities, as a group, hardened in the first half of 2004, as bad weather damaged crop prospects in a number of countries. Rice prices remained firm amidst supply concerns, especially as the crop in the major South Asian producers was reported to be affected by bad weather. During the course of the year, prices of key commodities such as wheat and oilseeds began to soften because of a bumper crop in the 2004-05 season. Despite strong demand, prices of oilseeds and oilseed-based products declined substantially in the latter half of 2004-05, as oilseeds production increased by 12 per cent during the year on the back of a bumper soya crop in Argentina, Brazil, China and the US. In sharp contrast to the previous year, global cotton prices softened through 2004 with production catching up with rising demand. World sugar prices, however, rose by about 28 per cent, on an average, during 2004-05 due to higher demand from developing countries, exacerbated by a decline in Chinese production for the second consecutive year.

I.3.32 Fuel prices rose sharply in 2004-05 amidst nervous sentiments in world markets about strong demand associated with a pick-up in economic activity, oil supply bottlenecks, low inventories and tight spare capacity (Chart I.15). Average international crude oil prices increased by 41.8 per cent from US $ 29.1 a barrel in 2003-04 to US $ 41.3 a barrel in 2004-05. In spite of periodic increases in supply by the Organisation of the Petroleum Exporting Countries (OPEC), a combination of adverse events such as

the effects of Hurricane Ivan on production sites along the Gulf of Mexico, financial difficulties of the major Russian producer, Yukos and a drop in US oil inventories on the eve of the winter season drove US crude oil prices to a high of US $ 55 per barrel in late October 2004. After a brief respite in November, crude prices resumed hardening and climbed above US $ 57 a barrel in early April, 2005 as the market discounted a further 0.5 million barrels a day increase in the OPEC output ceiling in March 2005 on the perception that most members were already producing at close to full capacity. Crude oil prices rose further to cross US $ 62 per barrel in early July 2005 notwithstanding the OPEC’s decision to further increase its production quota by 0.5 million barrels a day in its June 15, 2005 meeting as fears about hurricane-related supply disruptions in the Gulf of Mexico heightened. Notwithstanding forecasts of some deceleration in global oil demand in the rest of 2005, international oil prices continued to remain high and volatile, crossing US $ 67 a barrel on August 12, 2005 on concerns over stability of supplies from the Middle East and reports of slowdown in non-OPEC output.

I.3.33 Coal prices hardened in the first half of 2004-05 driven up by strong Chinese demand. Prices of metals, such as aluminium, copper, nickel, tin, steel and zinc hit multi-year peaks on the back of strong Chinese demand. The IMF’s metal price index rose by 30 per cent, on an average, in 2004-05. The World Bank’s composite index of steel products recorded an increase of 52 per cent during 2004-05.

I.3.34 In brief, the sharp rise in commodity prices in 2004-05 led to an increase in producers’ prices in most countries. However, there was not a commensurate increase in consumer price inflation as, due to competitive pressures, firms partly absorbed higher commodity costs into their profit margins. The resolve of monetary authorities to rein in inflationary expectations through measured policy responses also helped moderate the increase in consumer price inflation.

I.3.35 Headline inflation, measured by year-on-year (y-o-y) changes in the wholesale price index (WPI), moved in two distinct phases during 2004-05 (Table 1.24). The first phase covering April-August, 2004 witnessed a hardening of domestic prices of coal, petroleum products, iron ore and metals, reflecting essentially lagged adjustments to international prices. Petroleum product prices were revised upward twice in the first phase, effective June 16 and August 1, 2004. Besides, coal prices were also raised by 16.3 per cent in June 2004. The situation was exacerbated by the inadequate and uneven South-West monsoon which began to push up prices of food and non-food agricultural commodities by July 2004. Although rice prices hardened marginally, jowar price rise accelerated to double digits by August on expectations of a sharp decline in output of coarse cereals. Potato prices also rose sharply in the first half of the year as the unseasonal rainfall affected the crop on top of a lean season in 2003-04. As a result, headline inflation climbed to a peak of 8.7 per cent by end-August 2004, more than half of which was due to iron ore, metals, mineral oil and coal. It is against this backdrop that the Mid-term Review of the Annual Policy Statement placed the inflation rate for 2004-05, on a point-to-point basis, at around 6.5 per cent as against 5.0 per cent projected at the beginning of the year.

I.3.36 Inflation receded in the second phase beginning September 2004 as the adverse impact of the South-West monsoon turned out to be far more limited than perceived initially. This was led by a sharp decline in the prices of vegetables following the revival of the monsoon in August 2004. With the receding of drought fears, prices of oilseeds, edible oils, raw cotton and cotton textiles began declining in line with international trends.

Petrol prices, raised earlier on November 5, 2004, were moderated somewhat effective November 15, 2004. Sugar prices hardened during the year, reflecting reduced domestic supply which also affected international prices.

I.3.37 The impact of fiscal measures in the form of cuts in excise and customs duties in June and August 2004 cushioned the pass-through of the increase in international commodity prices to domestic inflation. The appreciation of the rupee against the US dollar during August-December 2004 (6.6 per cent) also offset some of the pressures of high international commodity prices on domestic inflation. Moreover, the administered nature of domestic urea prices limited the pass-through from high international prices. Administered prices of urea in India were not changed at all during 2004-05, despite an increase of 35 per cent in world urea prices. Finally, monetary policy measures by the Reserve Bank including an increase of 50 basis points in the CRR in September-October 2004, a 25 basis point increase in the reverse repo rate in October 2004 and re-introduction of overnight reverse repo in November 2004, along with the raising of ceiling of the MSS by Rs.20,000 crore signalled the resolve of the monetary authority to rein in inflationary expectations.

I.3.38 Headline inflation, year-on-year, eased to 5.1 per cent by the end of 2004-05 remaining close to the projection in the Annual Policy Statement for 2004-05. Annual average inflation, measured by annual changes in the average WPI, accelerated to 6.4 per cent in 2004-05 from 5.4 per cent a year ago (Chart I.16). Reflecting the supply side nature of inflation, year-on-year WPI inflation, excluding the fuel group worked out to 3.7 per cent in 2004-05 (5.2 per cent last year), well below the headline rate of 5.1 per cent.

I.3.39 Supply-side pressures dominated the inflation outcome in 2004-05. Mineral oil, coal, iron ore, iron and steel, sugar, and fr uits and vegetables - the key movers of headline inflation in 2004-05 with a combined weight of less than 20 per cent in the overall WPI index - accounted for more than three-fourth of the headline inflation in 2004-05. The contribution of various commodity groups to overall inflation underwent significant changes during 2004-05. The contribution of primary articles prices moderated to 5.5 per cent in 2004-05 from 8.5 per cent a year ago. The fuel group

accounted for as much as 42.7 per cent of the overall inflation during the year, up from 11.6 per cent in the previous year. The share of the manufactured products group declined to 52.0 per cent from 80.5 per cent in 2003-04 as the increase in sugar prices was more than offset by the decline in the prices of cotton, edible oils and oil cakes (Table 1.25 and Appendix Tables I.25 and I.26).

I.3.40 Raw cotton prices began to harden in July 2004, reflecting worries about the South-West monsoon. With the receding of supply concerns, cotton prices began to decline from September 2004 in line with international price movements. Domestic oilseeds prices hardened in the first half of 2004-05 on concerns about a crop failure resulting from the inadequate rainfall and uncer tainties over the possibilities of El Nino damaging Malaysian palm oil production. In order to contain rising prices, the Government reduced tariffs on vegetable oils in September 2004. Oilseeds and edible oils prices began to soften from end-September 2004 in line with international prices.

I.3.41 Sugar prices in India hardened in the latter half of 2004-05, reflecting the shortfall in output due to the deficient monsoon and higher international prices. International sugar prices were affected by the domestic situation as India is the world’s largest consumer as well as producer of sugar. Although the Government released higher free sale quota of sugar during the latter half of the year, prices of sugar continued to increase.