Annual Report

II.1 Against the backdrop of the growth peak in 2003-04, India’s macroeconomic performance in 2004-05 was heartening in the face of threats to growth from an unsatisfactory monsoon and upside risks to stability from high and volatile international crude oil prices. The improvement in rabi production helped in shoring up kharif output losses and imparting resilience to Indian agriculture. A distinct dynamism exhibited by the manufacturing sector underpinned a strong and well-distributed industrial recovery that contributed to acceleration in overall economic activity, infusing business confidence, export competitiveness and a pick-up in investment intentions. In conjunction with the sustained buoyancy of the services sector, these impulses of growth mitigated, to a large extent, the setback to agriculture. Accordingly, the Indian economy remained among the growth drivers of the global economy, which exhibited high overall growth despite various uncertainties and risks. Coordinated and carefully calibrated monetary and fiscal policies, deployed to address the spike in inflation during May-August, 2004 were successful in containing inflation to its desired trajectory in the last quarter of the year. Nevertheless, pressures from international crude prices as well as from the burgeoning domestic demand spilled over into the balance of payments, leading to strong import growth and a widening trade deficit signalling, to some extent, better absorption as well as resilience in the economy. Understandably, after recording surpluses for three years, the current account exhibited a deficit. Net capital flows were higher than those recorded in the previous year, partly reflecting global trends and partly drawn by the underlying strength of the macroeconomic fundamentals and outlook, the robust performance of the corporate sector and the attractive valuations of Indian financial markets. At the end of 2004-05, India’s foreign exchange reserves were the sixth largest in the world, surpassing the level of India’s external debt.

II.2 The manufacturing sector’s upsurge was the highlight of India’s macroeconomic performance during 2004-05, consolidating a phase of industrial recovery that began in 2002-03. Despite subdued activity in infrastructure, industries such as machinery and equipment other than transport equipment, chemicals and chemical products, cotton textiles and textile products contributed to the resurgence of the manufacturing sector. Capital goods and consumer goods sectors recorded double-digit growth, supported by a broad-based expansion in demand, both domestic and external. The coincident expansion of expor ts with the renewed growth of the manufacturing sector is indicative of the acquisition of the cutting edge of competitiveness and a greater penetration of overseas markets by Indian industry than before. Furthermore, the experience of 2004-05 also shows that a significant amount of innate resilience has been built up, especially in the context of exogenous shocks such as the deficient monsoon, the tsunami and soaring international oil prices.

II.3 The services sector consolidated and extended gains in activity during 2004-05. Within the services sector, trade, hotels, transpor t and communication has achieved an average growth of 9.8 per cent during the last five years. The trade and transport sectors benefited from factors such as the building of new highways, the cut in customs duty on the inputs of auto components which boosted the production of tractors and commercial vehicles, increase in cargo handled at major ports and increase in freight and passenger traffic of railways. Growth of the hotel industry was facilitated by a record increase in tourist inflows into the country. Lower tariffs in the cellular segment due to intense competition among the operators and higher penetration into the rural areas maintained the growth momentum in the telecommunication sector. The services sector continued to benefit from exports of software services, especially ITES-BPO, reflecting the ability of the Indian firms to execute larger and more complex projects as well as high value added services. Thus, buoyancy in the information technology sector, significant growth of the telecommunications and transport sectors, and strong foreign tourist arrivals contributed to maintaining the momentum in the services sector growth.

II.4 Despite a sharp rise in oil imports on the back of high international crude oil prices as well as a surge in non-oil imports reflecting growing domestic industrial demand, India’s balance of payments position remained comfortable with foreign exchange reserves increasing by US $ 28.6 billion during 2004-05.

There are significant shifts within the balance of payments that suggest that the economy may be approaching a turning point. First, the import-GDP ratio increased to 17.2 per cent in 2004-05, after hovering around 13 per cent during the previous five years. Second, export growth was robust, increasing by more than 20 per cent per annum for the third consecutive year in US dollar terms. Third, the merchandise trade deficit reached 5.5 per cent of GDP. The non-oil trade balance turned into deficit after a gap of four years. Fourth, overall earnings from net invisibles were buoyant, benefiting from steady growth in software and business services exports as well as remittances from expatriate Indians. However, net travel receipts were negative, because of the rapid expansion in outbound tourist from India, despite the jump in tourist arrivals. Furthermore, there was a sharp expansion in payments for business services in consonance with the modernisation of Indian industry. As in the past, the investment income account recorded net outflows on account of interest payments on external debt and profits and dividend payments. Nonetheless, more than four-fifth of the trade deficit was financed by the net invisible surplus. Fifth, there was a turnaround of US $ 17 billion in the current account balance during 2004-05 – a modest deficit of 0.9 per cent of GDP in 2004-05 from a surplus of 1.7 per cent of GDP in the previous year, 1.2 per cent in 2002-03 and 0.7 per cent in 2001-02. Sixth, the sharp increase in merchandise imports and the expanded external financing requirements led to a step-up in recourse to debt flows - trade credit and external commercial borrowings (ECBs) - alongside large investment flows pulled in by sustained investor optimism about India. Finally, positive aspects of these developments and the strength of the reserves created a congenial environment for expanding India’s foreign investment overseas reflecting India’s managerial, technological and entrepreneurial capabilities.

II.5 Given the growing integration of the Indian economy with the rest of the world, the external sector outcome during the year reflected global developments, particularly the movements in international oil prices and the uncertainties surrounding global macroeconomic imbalances and currency movements. The global oil economy continued to be characterised by elevated prices and considerable volatility, accentuated by speculative activities. Progressive withdrawal of the accommodative stance of monetary policy in the US alongside a weakening of economic activity in the euro area was yet another source of uncertainty for financial markets.

II.6 Public finances exhibited some consolidation in 2004-05, demonstrating a renewed commitment by the Government towards rule-based fiscal policy at the Centre and in a number of States. Notably, the revenue deficit in the Centre’s provisional accounts for 2004-05 declined by one percentage point of GDP over 2003-04, achieving twice the minimum stipulated annual reduction set under the Fiscal Responsibility and Budget Management (FRBM) Act/Rules. The reduction in the gross fiscal deficit, relative to GDP, was also higher than the FRBM target. Some headway in tax reforms was made by introducing new taxes, expanding the tax base and sprucing up tax administration while retaining stability in the tax rates. Expenditure management was geared towards reducing low priority expenditures and reorienting expenditures towards achieving physical targets. Nevertheless, low and shrinking capital outlays constraining the expansion of infrastructure and realisation of the full potential of the economy, emerged as a key concern. Fur thermore, the Government’s attempt to moderate the impact of spurting international oil prices by allowing only their partial pass-through to consumers has affected the performance of domestic oil companies.

II.7 A noteworthy aspect of macroeconomic management during 2004-05 was the success in restraining inflation and inflationary expectations in an environment of severe supply shocks emanating from a sharp rise in international crude oil prices and the setback to agricultural production caused by a deficient monsoon. Inflation, measured by movements in wholesale prices, reached its intra-year peak of 8.7 per cent by end-August 2004 before moderating to 5.1 per cent by end-March 2005 in response to calibrated policy measures. The policy response included fiscal measures in the form of cuts in excise and customs duties and monetary measures to withdraw excess liquidity from the financial markets.

II.8 While persevering with its objective of provision of liquidity to meet credit growth and support investment and export demand in the economy, monetary policy assigned relatively greater weight to price stability by switching from ‘a very close watch on the movements in the price level’ in the Annual Policy Statement (May 2004) to ‘equal emphasis on price stability’ in its Mid-term Review (October 2004). This was supported by a 50 basis points increase in the cash reserve ratio (CRR) in September-October 2004 and a 25 basis points hike in the reverse repo rate in October 2004. With a view to managing liquidity pressures emanating from large and persistent capital flows, sterilisation operations were undertaken through the liquidity adjustment facility (LAF) and open market operations, supported by the Market Stabilisation Scheme (MSS). These operations were successful in keeping monetary conditions stable and well within their indicative trajectories set out in the Annual Policy Statement for 2004-05.

II.9 Financial markets in India remained broadly stable during 2004-05, notwithstanding the uncertainty associated with the upturn in the global interest rate cycle and growing global macroeconomic imbalances. The introduction of the MSS, effective April 2004, provided the Reserve Bank with greater flexibility to absorb liquidity of a relatively durable nature and to modulate liquidity conditions in the financial markets, consistent with monetary and financial stability objectives. Comfortable liquidity kept money market segments aligned with the reverse repo rate during the greater part of the year. The foreign exchange market remained orderly, despite upward pressures on the rupee. Yields in the Government securities market hardened, mainly reflecting increase in the inflation rate due to higher crude oil prices and increase in the reverse repo rate. In the credit market, commercial credit offtake remained exceptionally strong and broad-based. The equity market staged unusually strong rallies from intra-year lows in May 2004.

II.10 The conduct of financial regulation and supervision in 2004-05 continued to be guided by the objective of maintaining confidence in the financial system by enhancing its soundness and efficiency. In addition to fine-tuning the prudential guidelines, the Reserve Bank focused on encouraging market discipline and ensuring good governance with an emphasis on ';fit and proper'; owners and diversified ownership. Steps to implement Basel II norms were carried forward through the Capital Adequacy Assessment Process. In respect of urban cooperative banks, the policy endeavour during the year aimed at developing them into a sound, well managed network of financial institutions providing quality banking services to the widest sections of society. Finally, the Reserve Bank stressed financial inclusion by emphasising the facilitation of transactions by the common person and strengthening of the credit delivery systems as a response to the pressing needs of society and the economy.

II.11 The Reserve Bank continued with its efforts to develop a sound and efficient payment and settlement system. During 2004-05, the thrust of the Reserve Bank’s policy initiatives was on widening the range of electronic payment products and building a sound institutional framework for regulation and supervision. The establishment of the National Financial Switch and the stabilisation of the real time gross settlement (RTGS) system were noteworthy developments during the year.

II.12 Leading indicators and available information for 2005-06 suggest that the Indian economy is poised to build upon the gains in macroeconomic performance secured in 2004-05. The revival of the South-West monsoon, robust strengthening of manufacturing activity, high corporate profitability, buoyant equity markets, robust merchandise exports and imports, sustained demand for non-food credit and lead indicators of services sector activity all point to a brightening of the near term prospects of the Indian economy.

II.13 According to the India Meteorological Department (IMD), the rainfall during the South-West monsoon season 2005 for the country as a whole is expected to be 98 per cent of the long period average with a model error of +/- 4 per cent. The monsoon, which was delayed by a week, recorded a deficiency of as much as 49 per cent till June 22, 2005. In the subsequent weeks, however, there was conspicuous improvement in rainfall activity. The cumulative rainfall during the period June 1 to August 17, 2005 was two per cent below normal as against seven per cent below normal during the corresponding period of the previous year. Of the 36 meteorological sub-divisions, cumulative rainfall was excess/normal in 29 subdivisions (28 sub-divisions during last year). Although the delayed arrival had an adverse impact on sowing of kharif crops, the sowing has started picking up. The Ministry of Agriculture is closely monitoring the situation and has issued advisories relating to sowing with specific suggestions to farmers on the likely agricultural operations they may undertake in the context of expected weather conditions. However, excess rainfall in some areas in the country during the last week of July 2005 not only impacted the economy of the industrial/commercial capital (Mumbai) but has also introduced some uncertainty regarding the eventual kharif outcome.

II.14 Industrial production gathered strength in April-June 2005 with growth accelerating to double digit. On a year-on-year basis, the growth of the manufacturing sector in June 2005 was the highest since June 1996. The electricity sector recorded a strong pick-up in May-June 2005 and the cumulative growth during April-June 2005 was higher than a year ago. Amongst other infrastructure industries, finished steel and cement recorded a robust turnaround in June 2005 from absolute declines a year ago while crude oil and petroleum refinery products remained lacklustre. According to the use-based classification, the capital goods sector maintained strong growth, reflecting increase in both investment and export demand. Growth of consumer durables accelerated, driven by demand for white goods and facilitated by ease in availability of financing. Consumer non-durables also recorded a substantial growth, partly reflecting the low base and high growth of food products. Basic goods accelerated during May-June 2005 and the cumulative growth during April-June was higher than a year ago. Intermediate goods, however, recorded deceleration, mainly due to a decline in the production of petroleum refinery products.

II.15 Various surveys of business confidence suggest considerable optimism about future prospects of industry. Corporate profits and new investment intentions are also at a record level. The optimistic investment climate, broadly stable bank lending rates, corporate profitability and the buoyancy in the stock markets suggest that the industrial sector outlook is likely to remain buoyant in 2005-06.

II.16 Lead indicators of services sector growth such as tourist arrivals, railways freight traffic earnings, cargo handled at major ports, cell phone connections, civil aviation and trends in bank deposits/credit indicate that the services sector is likely to maintain its growth momentum during 2005-06 as well.

II.17 Assuming a normal monsoon, and on the expectations that the industry and the services sectors would maintain their current growth momentum while absorbing the impact of oil prices, the Reserve Bank in its Annual Policy Statement for 2005-06 (April 2005) indicated that real GDP growth for 2005-06 could be placed around 7.0 per cent for the purpose of monetary policy formulation. This was reaffirmed in the First Quarter Review of the Annual Statement on Monetary Policy (July 2005).

II.18 Developments in merchandise trade during the first four months of 2005-06 show that both exports and imports have posted high growth. Non-oil import growth (38.1 per cent) mirrored the step-up in the pace of industrial activity while oil import growth (32.3 per cent) was largely the outcome of a continued rise in international crude oil prices. With growth in imports outpacing export growth - which was 21.3 per cent in US dollar terms - the merchandise trade deficit increased by 82 per cent during April-July 2005. Capital flows were steady during the first quarter. FDI inflows increased substantially while FII inflows recorded a sharp pick-up in June-July 2005. Data on approvals for the ECBs indicate continued demand for external finance for investments by corporates. As a result of these developments, the burgeoning trade deficit was accommodated by the invisibles surplus and net capital flows. The foreign exchange reserves increased by US $ 1.7 billion during 2005-06 (up to August 19, 2005).

II.19 The resurgence in service exports noticed in 2004-05 may be expected to continue as exports of business and professional services join software exports as key foreign exchange earners. The shift in the strategy of ITES-BPO industry segment of the software sector towards higher value activities and areas of competitive strength would yield rich dividends if supported by preparedness to meet data security requirements and to fulfil regulatory compliance requirements in the banking and financial services sector. Workers’ remittances seem to have acquired a permanent character and hence should continue to be an important source of inflows with an ongoing transition to higher skill categories in overseas markets. Thus, there are grounds to hold that the buoyancy in net invisible earnings will be maintained and even built upon, despite rising invisible payments. On the other hand, despite the sustained strength of export performance, the merchandise trade deficit is expected to be somewhat higher in 2005-06 than the previous year mainly on account of substantially higher oil and non-oil imports. For the year as a whole, while invisibles surplus may finance a large part of the enlarged trade deficit, the current account deficit is expected to widen during 2005-06 but to remain within acceptable limits that can be financed by normal capital flows.

II.20 Continuing and emerging global uncertainties embedded in the pace of the tightening of interest rates in the US, asset price movements and the manner of unwinding of global macroeconomic imbalances would have a bearing on capital flows to emerging market economies (EMEs). However, the underlying strength of the Indian economy and the prudent policy approach should enable containment of excess volatility in capital flows to India. Backed by progressive liberalisation of the investment environment, Indian companies are also expanding and diversifying their operations across a wider spectrum of countries, leveraging advantages in terms of diffusion of technical innovation and managerial expertise. The notable optimism in India’s growth prospects has increased interest in investment in India.

II.21 Although headline inflation edged up during April 2005 driven up by prices of fruits and vegetables and some freely-priced items in the fuel group, it eased in the subsequent months despite hikes in the prices of electricity and petrol and diesel. Annual WPI inflation rate was 3.4 per cent as on August 6, 2005, down from 5.1 per cent at end-March 2005. More than one-half of the annual inflation was on account of the fuel group, even as the pass-through from high international crude oil prices has remained incomplete. Excluding the fuel group, annual inflation was 1.8 per cent as on August 6, 2005, significantly lower than headline inflation. During 2005-06 so far, oil prices in the international markets continue to remain high and volatile. The average price for a basket of major international crude varieties (Brent, WTI and Dubai Fateh) at around US $ 52.2 per barrel during April-July 2005 was 13.1 per cent higher than in January-March 2005 and 44.1 per cent over the corresponding period of last year. With the latest hike in prices effective June 20, 2005, the average domestic price of petrol and diesel (in four metros) has increased by 6.2 per cent over the end-March 2005 level and 22.4 per cent over the level a year ago. The pass-through of crude prices continues to remain the most critical factor influencing domestic inflation. Annual inflation, as measured by variations in the consumer price index (CPI) for industrial workers, on a point-to-point basis, was 3.3 per cent in June 2005 as compared with 3.0 per cent a year ago.

II.22 The Reserve Bank sought to moderate inflationary expectations by a demonstrable commitment to price stability through successive increases of 25 basis points each in the reverse repo rate in October 2004 and April 2005. On balance, underlying inflationary pressures appear to have been contained during 2005-06 so far and the inflation outcome, under normal circumstances, as noted in the First Quarter Review of the Annual Statement on Monetary Policy (July 2005), is expected to be consistent with the Annual Policy Statement’s projection for annual point-to-point inflation for 2005-06 in the range of 5.0-5.5 per cent.

II.23 The performance of Central Government finances during 2005-06 has so far been in line with the budget estimates. The Central Government’s finances during April-June 2005 were characterised by substantially higher revenue receipts mainly on account of tax revenue, with non-tax revenue registering a marginal growth. The growth in tax revenue was supported by buoyant collections of corporation tax and customs duties. The growth in aggregate expenditure decelerated mainly on account of lower capital expenditure, particularly defence, and deceleration in revenue expenditure. On the whole, the revenue deficit registered a marginal growth of 2.0 per cent during April-June 2005 over its level in the corresponding period of the previous year. The gross fiscal deficit (GFD) increased by 30.8 per cent as compared with an increase of 8.0 per cent during April-June 2004 reflecting the impact of the discontinuance of the debt swap scheme from 2005-06. The GFD, however, showed a decline during April-June 2005 over its level during April- June 2004, when adjusted for debt swap proceeds.

II.24 Gross market borrowings during 2005-06 (net of the MSS) of the Centre were budgeted at Rs.1,65,467 crore, while net market borrowings were placed at Rs.1,03,791 crore. During 2005-06 (up to August 19, 2005), 50.9 per cent of the gross market borrowing programme has been completed as compared with 51.7 per cent during the corresponding period of 2004-05. The weighted average yield on fresh government borrowings through dated securities increased from 6.11 per cent in 2004-05 to 7.28 per cent during the current year so far (up to August 19, 2005) while the weighted average maturity fell from 14.13 years to 14.04 years over the same period. In addition to normal market borrowings, the Central Government raised Rs.6,104 crore (face value) under MSS for sterilisation purposes during 2005-06 so far (up to August 19). Overall, the net resources raised through Government securities (Centre, States and MSS) amounted to Rs.59,359 crore (face value) during 2005-06 so far as compared with Rs.70,307 crore in the corresponding period of the previous year.

II.25 As the demand for non-food credit remained strong, scheduled commercial banks financed the credit demand from the commercial sector by restricting their incremental investments in Government and other approved securities to Rs.27,942 crore up to August 5, 2005 as against an increase of Rs.55,152 crore in the corresponding period of the previous year. The effective statutory liquidity ratio (SLR) of the commercial banks declined to 37.4 per cent of net demand and time liabilities (NDTL) as on August 5, 2005 from 41.7 per cent a year ago but continues to remain above the statutory minimum of 25 per cent.

II.26 Despite the strong surge in demand for bank credit, monetary conditions have remained easy during 2005-06 so far (up to August 19, 2005) reflecting liquidity management operations by the Reserve Bank. Responding to a widening of the trade deficit, a marked increase in the demand for bank credit from the commercial sector and the onset of the Government borrowing programme, the Reserve Bank injected primary liquidity into the system. The absorption of liquidity through increase in balances under the MSS, till July 22, 2005, was more than offset by liquidity released through the unwinding of LAF. In the first week of August 2005, the balances under LAF reverse repos increased sharply reflecting larger foreign exchange inflows as well as reduction in the Central Government’s surplus cash balances. Reserve money expanded at a higher rate than a year ago. Nonetheless, the

cent as on August 5, 2005 was consistent with the indicative trajectory of 14.5 per cent set out in the Annual Policy Statement for 2005-06. The commercial sector’s demand for bank credit remained strong, with year-on-year non-food credit growth of scheduled commercial banks reaching 30.2 per cent as on August 5, 2005 on top of 24.4 per cent a year ago. Disaggregated data available for the first two months show that credit demand is fairly broad-based. In particular, credit to industry, housing and real estate continued to record strong growth. More recent information on industrial credit up to June 2005 indicates significant increase in credit to metals and metal products, engineering, power and roads and ports. However, the continued upswing in credit demand for housing and real estate suggests a greater focus on credit quality. Accordingly, the Reserve Bank increased risk weights on exposures of banks to commercial estate and capital markets from 100 per cent to 125 per cent on July 26, 2005.

II.27 Financial markets were largely stable during the first four months of 2005-06, even as interest rates edged up. Money market rates were generally aligned with the reverse repo rate. Yields on 10-year Government securities edged up by 43 basis points between end-March 2005 and August 19, 2005 reflecting concerns over the continued rise in international crude oil prices as well as liquidity pressures due to sustained credit demand. With a relatively higher increase in long-term interest rates, there was a steepening of the yield curve. The Indian rupee appreciated vis-à-vis the US dollar by 0.4 per cent between end-March 2005 and August 19, 2005, partly due to expected revaluation of the Chinese currency, which crystallised on July 21, 2005.

II.28 The outlook for the Indian economy has to reckon global economic activity which is expected to decelerate to 4.3 per cent in 2005 from a three-decade peak of 5.1 per cent recorded in 2004. There are already signs of a slackening of momentum in the first half of 2005 in some areas of the industrialised world. Among developed countries, growth has been strong in the US, albeit lower than a year ago. The Euro zone has exhibited low growth. Among the EMEs, growth has remained strong in China and India, whereas in other Asian and Latin American countries there has been some loss of pace. During the second quarter of 2005, consumer price inflation decreased in the US, but remained stable in the Euro zone, Japan and other advanced economies. Inflation in other major emerging markets and developing countries has also shown some decline during this quarter. The rise in oil prices has not yet triggered generalised inflationary pressures in contrast to the experience of earlier oil shocks.

II.29 As regards international crude oil prices, the outlook remains highly uncertain with limited scope for enhanced supplies in the near future, taking account of inventories, unutilised capacities and gestation periods for new investments. The geopolitical factors seem to continue to be critical. While the global economy is coping with these uncertainties in a demonstrably better manner than in earlier episodes, the associated problems are getting complex for oil-exporting countries in terms of managing the surpluses and difficult for oil-importing countries like India in terms of effect on prices, output, competitiveness and indeed, disposable incomes. Risks to global growth also arise from the imbalances in the current account of the BoP, the fiscal imbalances, hedge fund activity, elevated asset prices and the excessive leveraging in some advanced economies. The current macro-policy framework of most emerging economies has imparted notewor thy resilience, but heightened global uncertainties do demand close attention to elements of the recently accentuated disequilibria.

II.30 In this context, a recent development with important consequences for the global economy is the decision by the Chinese authorities to move away from the peg to the US dollar to a managed floating exchange rate regime linked to a basket of currencies, with an initial appreciation of the renminbi (RMB) by 2.1 per cent against the US dollar. In the subsequent period up to August 19, 2005, the yuan has moved in a narrow range of 8.0976-8.1127 RMB per US dollar. The nature, extent and intensity of management of the exchange rate is yet to be revealed and the associated administrative measures by the authorities would have to be watched to determine the impact of these changes on the global economy. Of particular significance would be the ongoing responses of the domestic financial as well as real sectors in China to the new foreign exchange policy. As per current indications, the impact on India is assessed to be marginally positive on trade account, neutral on current account, and somewhat uncertain on capital flows but is unlikely to be negative for India, though the capital flows could be potentially volatile on the global front.

II.31 The domestic factors, which are more relevant for India, continue to be positive. The performance of the industrial sector is strengthening and the indicators of growth in services are positive. The business expectation surveys also point to continued optimism. While the onset of monsoon was delayed, it has progressed well subsequently, but uncertainties remain on its progress during the season and consequently its impact on agricultural output. During the current year so far, the underlying inflationary pressures appear to have been contained and inflationary expectations maintained, as anticipated. On balance, though uncer tainties and supply constraints remain, the domestic growth impulses appear to have been reinforced in the first quarter.

II.32 Given the volatility in the inflation rate during 2004-05, there is a need to consolidate the gains obtained in recent years from reining in inflationary expectations. While sustained efforts over time have helped to build confidence in price stability, inflationary expectations can turn adverse in a relatively short time if noticeable adverse movements in prices take place. Credible commitment of policy to fight inflation is critical to stop translation of higher oil prices into wage-price spirals. In addition, the international prices of non-oil primary commodities may continue to remain firm. On the domestic front, the manoeuvrability on oil prices is getting limited and corporates have a higher probability of gaining their pricing power with a better industrial outlook. The pricing pressure, if it were to occur from the supply side, could get complicated by continuing overhang of excess domestic liquidity. While the economy has the resilience to withstand supply shocks, the upside risks do exist. As such, the inflationary situation needs to be watched closely to persevere in maintaining inflation expectations and any complacency on this count could have adverse consequences for both stability and growth.

II.33 In brief, although there are several global uncertainties, domestic factors indicate a confidently growing economy in a stable environment. While global factors are getting to be increasingly significant for India, the domestic factors still dominate and the latter point to favouring stability to maintain the growth momentum at this juncture while watching inflationary situation closely to persevere in maintaining inflation expectations. It is in this context that key medium-term issues which will entrench the conditions for high growth with stability merit attention.

II.34 The experience of 2004-05 brings to the fore, yet again, the rain dependence of Indian agriculture. In this context, imparting stability to farm incomes assumes critical significance. Globalisation, rising incomes and urbanisation have brought into focus the need for increasing diversification and value addition in Indian agriculture. The new demand patterns as well as the shifts in consumption warrant a shift of land and other resources to crops with higher potential for value addition. India has considerable export potential in areas such as dairying, sericulture, floriculture and horticulture. This segment, besides enhancing nutritional and livelihood standards, sustains a large number of agro-industries which hold rich potential for non-farm employment.

II.35 In this context, it needs to be recognised that agriculture had a limited or no direct role to play in providing additional employment opportunities in the recent decade. Employment in agriculture remained virtually unchanged at about 190 million people during the 1990s. Concomitantly, the employment growth for the economy, as a whole, decelerated from above two per cent during the 1980s to only 1.1 per cent in the latter half of the 1990s. With the growth rate of working age population exceeding the overall population growth rate, the unemployment rate could worsen further if the economic growth envisaged does not give rise to new activities that are appropriately labour intensive.

II.36 There is a need to evolve and put in place appropriate agricultural technologies and agro-management practices to respond to food and nutritional security, poverty alleviation, diversifying market demand, expor t oppor tunities and environmental concerns. It is expected that future agricultural growth would largely accrue from improvements in productivity of diversified farming systems with regional specialisation and sustainable management of natural resources, especially land and water. Effective linkages of production systems with marketing, agro-processing and other value added activities would play an increasingly important role in diversification of agriculture.

II.37 Strengthening the marketing and infrastructure network as also amendment of State Agricultural Produce Marketing Committee (APMC) Acts in line with the Model Act (2003) in all the States would go a long way in enhancing market efficiency and promoting exports and processing industry. The Act would, inter alia, facilitate direct sale, promotion of public-private partnership in the management and development of agricultural markets, promotion of contract farming, pledge financing, trading, export, forward/future trading and introduction of a negotiable warehousing receipt system in respect of agricultural commodities.

II.38 A welcome development in the past few years is the strong increase in bank credit to the agricultural sector. Credit to the agricultural sector increased by 35.2 per cent during 2004-05 on top of an increase of 23.2 per cent during the previous year. It is important that this trend should continue. In this context, the changing demand pattern for food involves a reordering of priorities in organising appropriate supply responses. Supporting policy changes and investment are required to facilitate agricultural diversification and value-addition. In the new growth areas of agriculture, the importance of post harvest activities such as storage, transportation, processing and marketing of non-cereal products increases which leads to greater links between agricultural diversification and rural industrialisation. Heavy investments need to be made in establishing cold chains across the country such as cold storage, transport facilities and the like. In fact, credit requirements would go up due to purchased-input intensive and heterogeneous production cycles of the new areas of agriculture. This would also call for designing innovative schemes and products which recognise the differing nature of agri-business and supply chains for different products. Newer forms of credit assessment and risk management systems may also have to be put in place, besides upgrading skills, and ushering in changes in attitudes and mind-sets. Information technology has to be used to facilitate transformation in various processes of rural credit. It is heartening to note that several banks have adopted policies to direct increased credit to agriculture, but greater attention to structural, institutional and procedural systems may be needed to ensure not only a sustained growth in credit to agriculture and related activities but also provision of a range of financial services. These steps towards diversification of agriculture in favour of value added services such as those related to the food processing and livestock sectors would also provide stable additional avenues of employment generation in the rural sector and enable these sectors to emerge as the main source of growth and employment in rural areas.

II.39 Rural infrastructure - irrigation structures, agriculture research and extension, transpor t infrastructure, electricity, storage structures - not only enhances the productivity of physical resources but also helps in supply chain management and value addition in agriculture. Promotion of micro-irrigation technology (comprising drip and sprinkler irrigation) on a large scale deserves priority, particularly in view of the fact that water use efficiency in Indian agriculture is one of the lowest in the world. The approach to the development of the rural infrastructure would need to stress the importance of water management, the criticality of assured power supply, high quality of inputs and risk mitigation strategies including cushioning the possible adverse impact of tariff rationalisation under the WTO.

II.40 The recovery in the industrial sector which set in during 2002-03 has steadily become entrenched and diffused. The overall investment climate during 2004-05 was buoyant. A significant investment revival is suggested by the very substantial increase in investment intentions registered in 2003-04 and further doubling in 2004-05. Robust export growth reflects the growing competitiveness of Indian industry. Strong corporate profitability in the past few quarters, even in an environment of heightened competitiveness, suggests that the efforts by the Indian industry to restructure itself are paying off. Continuing strong growth in non-food credit and in imports of capital goods and buoyant capital markets indicate that industry is likely to remain buoyant in 2005-06. The congenial policy regime in regard to mergers and acquisitions including the liberalisation of policies in regard to direct investment abroad has encouraged consolidation of Indian industry and enabled the reaping of the benefits of economies of scale. This has impar ted a high degree of competitiveness to Indian industry. In view of the enhanced external as well as internal competition, further consolidation through scale economies is likely to remain an important driver of industrial growth in the future. It is, therefore, critical that the current upsurge in the industry is nurtured in order for India to realise its growth potential.

II.41 In this context, there are a host of infrastructural bottlenecks which could impinge upon competitiveness and the supply elasticities to meet the emerging global and domestic demand. The subdued performance of the infrastructure sector, especially that of crude petroleum and petroleum refinery products, is an issue of concern, given the sector’s strong forward and backward linkages in the economy. The increasing demand-supply gap in the availability of power is becoming the most critical issue in the future of India’s economic development. Inadequate power generation capacity, lack of optimum utilisation of the existing generation capacity, insufficient inter-regional transmission links, inadequate and ageing sub-transmission and distribution network, slow pace of rural electrification and inefficient use of electricity by the end consumer have exacerbated the absolute shortages. In the recent period, shortage of coal and gas has emerged as a serious constraint on power generation with the supply of both fuels falling far short of demand. A number of thermal plants are reported to be running with critical coal stocks of less than a week, with adverse impact on the plant load factor. Shortages of gas were reflected in long hours of load shedding in Maharashtra in May 2005. Imports of coal and gas are hampered by the sharp surge in international prices of these commodities. Continuing problems in the power sector pricing policy suggest an urgent need of reforms to ensure payment security. The untapped hydro electricity sources have to be explored to generate inexpensive electricity. Besides, there is a need to consider generation through nuclear energy also to meet the expected surge in demand for energy accompanying the anticipated growth in the medium-term. In any case, having recognised the fact that the Indian economy is among the more inefficient users of energy, highest and urgent priority needs to be given for energy-saving measures, which could include appropriate pricing policies and incentives to invest. In this context, there is a need for a greater degree of pass-through of higher international crude oil prices to domestic prices. This will also enable more efficient use of oil in the economy, especially in view of the fact that the rise in international oil prices appears to have a large permanent component.

II.42 With growing urbanisation, issues related to urban infrastructure have come to the forefront. Urban infrastructure consists of drinking water, sanitation, sewage systems, electricity and gas distribution, urban transport and primary health services. At present, investment in urban infrastructure is hampered by the fact that local governments are not yet creditworthy and urban infrastructure projects are, therefore, not found to be commercially viable. Strengthened planning and better coordination between various agencies entrusted with maintenance of urban infrastructure would have a positive impact on the overall productivity of economic activity in cities. Limitations of urban infrastructure were evident during the recent heavy rains in Mumbai and rest of Maharashtra during the last week of July 2005. Given the fact that there is a heavy concentration of economic activity in large cities, weak infrastructural facilities impede the growth of large cities. It is, therefore, of utmost importance that the quality of urban infrastructure in the large cities is improved significantly so as to maintain and accelerate the momentum of economic growth and productivity enhancement. For urbanising economies like India to replicate the experience of developed countries in the provision of urban infrastructure, it is essential that all aspects of city management, including the fostering of a professional workforce, are strengthened. This, in turn, would increase the creditworthiness of city governments and help attract the investment necessary for vital urban infrastructure projects.

II.43 Small and Medium Enterprises (SMEs) are an important segment in the industrial spectrum of the country owing to their contributions to employment generation, value addition and exports. The process of de-reservation has been carried forward during 2005-06 with a further de-reservation of 108 items from exclusive production by SSI units in order to permit the sector to reap the economies of scale and to enhance competitiveness. The proposed debt restructuring mechanism for the SME sector would improve their financial health and also protect them from the incidence of sickness. In this context, a noteworthy development is the passing of the Credit Information Companies (Regulation) Act, 2005 by the Parliament. This Act is expected to encourage setting up of credit information companies and, thereby improve exchange of information on credit histories of the borrowers and, with appropriate risk assessment techniques in place, should lower transaction costs of the banks. In turn, this is likely to lead to an increase in bank lending to SMEs while, at the same time, it is expected that the risk premium embedded in interest rates charged to SMEs will be reduced.

II.44 The delay in implementation of several central sector projects needs careful monitoring. While the cost overrun for delayed projects as a percentage of original cost declined from 51.8 per cent in March 2004 to 45.2 per cent in March 2005, the number of delayed projects increased from 112 to 125. Procedural bottlenecks and other problems relating to allocation of funds and acquisition of land continue to deter the implementation of majority of the projects, particularly in the railway sector. A reduction of 10 per cent in the cost overrun of delayed projects would yield substantial savings of around Rs.2,500 crore.

II.45 The services sector remains the growth driver of the economy, with a contribution of more than 57 per cent of GDP. India ranked 18^th among the world’s leading exporters of services with a share of 1.3 per cent in world exports. The services sector is expected to benefit from the ongoing liberalisation of the foreign investment regime into the sector. Software and the ITES-BPO sectors have recorded an exponential growth in recent years. The continued buoyancy in this sector is sustainable in the medium term in view of enabling policy developments, encouraging investment climate, improvement in business expectations, affordable labour force, talented technological manpower, time zone advantages, improved telecommunication facilities and above all, a low cost destination for outsourcing. India’s strengths in legal and contractual obligations, apart from a large scientific and technological talent pool, need to be effectively explored. The ITES sector is labour intensive and holds promises of higher employment. To improve international confidence and realise the full potential of the software and services sector, added emphasis may be warranted in regard to infrastructure as well as in the implementation of strong security solutions.

II.46 Consolidation of Central Government finances so as to achieve the targets set under the FRBM by 2008-09 is the goal of fiscal policy, notwithstanding the ‘pause’ that has been set during 2005-06. Since 2002-03, Central Government finances have recorded a progressive reduction in key deficit indicators. This has been, inter alia, enabled by attempts to increase the tax base which is reflected in a sustained increase in tax/GDP ratio from 8.8 per cent in 2002-03 to 9.9 per cent in 2004-05 and an expected 10.6 per cent in 2005-06. Moreover, the recovery in economic activity, especially in the industrial sector, has also enabled an improvement in the tax/GDP ratio and Central Government finances. Against this backdrop, with the GFD/GDP ratio at 4.1 per cent in 2004-05 (provisional accounts), the FRBM target of 3.0 per cent by 2008-09 appears to be within striking distance. However, with the revenue deficit at 2.6 per cent in 2004-05, the elimination of the revenue deficit by 2008-09 will prove to be more difficult. Achieving this target requires continued focused action on containing expenditures, increase in tax revenues and reduction in tax exemptions. Revenue augmentation would critically depend upon improvement in tax/GDP ratio as non-tax revenue is set to decline in the coming years. With the acceleration in overall economic growth that is being observed currently, renewed efforts on tax compliance should yield beneficial results. This assumes further urgency in the context of the higher devolution of tax revenues by the Centre to the State Governments as recommended by the Twelfth Finance Commission (TFC). Non-debt capital receipts are also slated to decline under the TFC’s scheme of debt write-off to be awarded to States on the basis of reduction of their revenue deficits. Discontinuance of the practice of treating disinvestment proceeds as budgetary receipts will also reduce non-debt capital receipts. Overall, despite the recent improvements in the fiscal position of the Central Government, the effort in achieving fiscal consolidation will have to continue.

II.47 Achievement of the FRBM target of revenue deficit at zero per cent of GDP will free up resources for public investment which will crowd-in private investment. Hence, in addition to efforts to improve revenues, expenditure management centres around the enhancement of the effectiveness of the delivery mechanism for public services. The phasing out of the Centre from intermediation of States’ borrowings, as recommended by the TFC, would provide some space for the Central Government to undertake larger capital outlay. Further, the Government’s proposal to announce an ‘outcome budget’ which evaluates projects in terms of outcomes rather than outlays will enable an improvement in the quality of investment. II.48 The fiscal scenario is also conditioned by the prevailing global uncertainties in respect of crude oil prices and capital flows. Spikes in crude oil prices could result in increased fiscal burden in terms of duty concessions, larger petroleum subsidies or lower dividends from oil PSEs. Furthermore, holding back the pass-through of international prices to domestic prices involves quasi-fiscal costs which could eventually turn into a binding constraint for the fiscal authority.

II.49 The fiscal position of the States during 2005-06 would, to a large extent, be shaped by the recommendations of the TFC and the implementation of Value Added Tax (VAT). Another impor tant development relates to enactment of Fiscal Responsibility Legislation (FRL) by several States and proposals to enact legislation by some others. The Union Government has accepted the major recommendations of the TFC and has incorporated them in the Union Budget, 2005-06. An analysis of budget documents of the State Governments reveals that many of them have not factored in the TFC’s recommendations pertaining to resource devolution. Most of the States have switched over to a VAT regime on the basis of recommendations of the Empowered Committee of State Finance Ministers (Chairman: Dr. Asim Kumar Dasgupta). The VAT system would eliminate the problems of cascading tax burden due to double taxation of commodities as well as multiplicity of taxes through provision of input tax credit and abolition of other related indirect taxes. It is also expected to enhance transparency, promote compliance and lead to higher revenue mobilisation. While the implications of introduction of VAT on States’ resource generation are yet to emerge, the experience of Haryana - the first State to introduce VAT in April 2003 - has been encouraging from the point of view of revenue generation. In this context, there may be a merit in extending the VAT principles to tax the consumption of almost all goods and services in the economy.

II.50 The fiscal position of State Governments for 2005-06 would continue to undergo correction in terms of key deficit indicators through containment of non-interest revenue expenditure. Accordingly, fiscal empowerment to augment resource mobilisation from non-tax revenues through appropriate user charges, cost recovery from social and economic services and restructuring of State PSUs assumes importance. Improvement in State finances will enable the States to step up their expenditures on education and health with a beneficial impact on the quality of life and the country’s ranking in terms of the Human Development Index. In the recent years, exports of services such as software and ITES-BPO services have recorded strong growth. For this growth momentum to be maintained, it is necessary that public expenditure on education should reverse its declining trend: total expenditure by the State Governments on education is budgeted to decline from 2.5 per cent of GDP in 2003-04 to 2.3 per cent in 2005-06. Moreover, given the demographic profile, the demand for education is slated to increase further. Accordingly, the improvement in State finances will enable the States to increase their expenditure on education and other social services and thereby improve the quality of overall social infrastructure so that India can realise its potential.

II.51 The health of public finances will benefit vastly from improvements in cost recovery of various public services and rationalisation of subsidies. At present, user charges are inadequate for two reasons. First, it is perceived that the services are provided by the Government and, therefore, do not have to be paid for. Second, with the quality of the service being poor, the public is loath to pay higher charges. The attainment of higher efficiency in the provision of services can progressively lead to lower charges. Better cost recoveries will not only improve public finances but will also create enabling grounds for financial sector development so that each activity becomes financially viable.

II.52 Various reforms in the trade policy regime have unlocked entrepreneurial energies, stepped up productivity gains and improved competitiveness and access to overseas markets. India’s merchandise exports have been rising at a rate of over 20 per cent per annum, in US dollar terms, during 2002-05. As a result, the secular decline in India’s share in world exports from two per cent in 1950 to 0.5 per cent in the 1980s has been reversed. This share began rising in the 1990s and is currently at 0.8 per cent. These positive developments in the external sector provide the environment of pursuing a further rationalisation of tariffs with a view towards moving to a single, uniform rate on imports, say 10 per cent, and simplifying all customs procedures strictly in line with best global practices. This should help to improve competition, expor ts and domestic consumers. The current external environment, including the level of the foreign exchange reserves, enables such a move to be made with little or no downside risks.

II.53 While the recent trend in imports may continue to persist in the face of high and volatile crude oil prices and the large increase in domestic demand, an intrinsic link between merchandise imports and exports has emerged and become entrenched. The large expansion in imports is also spurring vigorous export growth. Given the recent experience, especially the fact that remittances from Indians employed abroad seem to have acquired a permanent character, the current level of the trade deficit appears to be manageable at this stage and appears to be consistent with India’s growth aspirations.

II.54 In regard to capital flows, India has adopted a policy of active management of the capital account. The compositional shifts in the capital account towards non-debt flows since the early 1990s have been consistent with the policy framework, imparting stability to the balance of payments. The substitution of debt by non-debt flows also gives room for manoeuvre since debt levels, particularly external commercial borrowings, have been moderate. There is also the cushion available from the foreign exchange reserves. Since non-debt creating flows are dominating, the emphasis is on encouraging inflows through foreign direct investment and enhancing the quality of portfolio flows by strict adherence to what may be described as ‘Know Your Investor’ principle. Prudential regulations over financial intermediaries, especially over banks, in respect of their foreign exchange exposures and transactions are a dynamic component of management of the capital account as well as financial supervision.

II.55 India has made significant progress in financial liberalisation since the institution of financial sector reforms in 1992 and this has been recognised internationally. India has chosen to proceed cautiously and in a gradual manner, calibrating the pace of capital account liberalisation with underlying macroeconomic developments, the state of readiness of the domestic financial system and the dynamics of international financial markets. Unlike in the case of trade integration, where benefits to all countries are demonstrable, in the case of financial integration, a ';threshold'; in terms of preparedness and resilience of the economy is important for a country to get full benefits. A judgmental view needs to be taken whether and when a country has reached the threshold and the financial integration should be approached cautiously, preferably within the framework of a plausible roadmap that is drawn up by embodying the country-specific context and institutional features. The experience so far has shown that the Indian approach to financial integration has stood the test of time.

II.56 The optimism generated by the recent gains in macroeconomic performance warrants a balanced consideration of further financial liberalisation. At this stage, the optimism generated by impressive macroeconomic performance accompanied with stability has given rise to pressures for significantly accelerating the pace of external financial liberalisation. It is essential to take into account the risks associated with it while resetting an accelerated pace of a gradualist approach. The recent experience in many countries shows that periods of impressive macroeconomic performance generate pressures for speedier financial liberalisation since everyone appears to be a gainer from further liberalisation, but the costs of instability that may be generated in the process are borne by the country, the government and the poorer sections. Avoiding crises is ultimately a national responsibility. The approach to managing the external sector, the choice of instruments and the timing and sequencing of policies are matters of informed judgment, given the imponderables.

II.57 The overall approach to the management of India’s foreign exchange reserves in recent years reflects the changing composition of the balance of payments and the ‘liquidity risks’ associated with different types of flows and other requirements. The policy for reserve management is thus judiciously built upon a host of identifiable factors and other contingencies. Taking these factors into account, India’s foreign exchange reserves continue to be at a comfortable level and consistent with the rate of growth, the share of the external sector in the economy and the size of risk-adjusted capital flows.

II.58 With increasing financial sector liberalisation and emergence of financial conglomerates, financial sector stability has emerged as a key objective of the Reserve Bank. In this context, the recent emphasis in the regulatory framework in India on ensuring good governance through ';fit and proper'; owners, directors and senior managers of the banks infuses a qualitative dimension to the conventional discharge of financial regulation through prescribing prudential norms and encouraging market discipline. In totality, however, these measures interact to produce a positive impact on the overall efficiency and stability of the banking system in India. There has been a marked improvement in capital adequacy, asset quality and the profitability of the banking system. Commercial banks in India will start implementing Basel II with effect from March 31, 2007. They will adopt the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk, initially. After adequate skills are developed, both at the banks and also at supervisory levels, some banks may be allowed to migrate to the Internal Rating Based Approach. Banks have also been advised to formulate and operationalise the Capital Adequacy Assessment Process as required under Pillar II of the New Framework.

II.59 Implementation of Basel II will initially require more capital for banks in India in view of the fact that operational risk is not captured under Basel I, and the capital charge for market risk was not prescribed until recently. Consequently, banks are exploring all avenues for meeting the capital requirements under Basel II.

II.60 Above all, capacity building, both in banks and the regulatory bodies is a serious challenge, especially with regard to adoption of the advanced approaches. The Reserve Bank has accordingly initiated supervisory capacity-building measures to identify the gaps and to assess as well as quantify the extent of additional capital which may be required to be maintained by such banks.

II.61 Compared to other developing countries, the extent of rating penetration in India has been increasing every year and a large number of capital issues of companies have been rated. However, since rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I standards for credit risks in respect of non-retail exposures. While Basel II provides some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to rating of issuers. Encouraging rating of issuers would be essential in this regard. In this context, current non-availability of acceptable and qualitative historical data relevant to ratings, along with the related costs involved in building up and maintaining the requisite database, does influence the pace of migration to the advanced approaches available under Basel II.

II.62 In the current scenario, banks are constantly pushing the frontiers of risk management. Compulsions arising out of increasing competition, as well as agency problems between management, owners and other stakeholders are inducing banks to look at newer avenues to augment revenues, while trimming costs. Consolidation, competition and risk management are no doubt critical to the future of banking but governance and financial inclusion are also likely to emerge as the key issues for a country like India, at this stage of socio-economic development.

II.63 The recent trends in credit demand are encouraging although there is a recognition of a greater need to ensure credit quality. It is important that the sharp increase in credit flow to the rural sector witnessed during the past two years is maintained while reducing intermediation cost so that borrowing costs also come down. The thrust of the current strategy adopted by the Reserve Bank to increase the flow of rural credit is on enhancing credit delivery in a regime of reasonable credit prices within the existing legal and institutional constraints. It is noteworthy that the share of small and marginal farmers in credit disbursed by public sector banks under the Special Agricultural Credit Plans has increased from 26.7 per cent during 2002-03 to 31.9 per cent during 2004-05. In order to further strengthen these efforts, there is, first, a need for legal and institutional changes relating to governance, regulation and functioning of rural cooperative structure and Regional Rural Banks (RRBs) which would have to be, as originally envisaged, critical instruments for rural credit. The changes warranted in cooperatives as well as RRBs involve deep commitment of State Governments and have a significant bearing on the political economy. Second, the overhang problems of non-performing loans and erosion of deposits in both cooperatives and RRBs have an inevitable fiscal impact of any scheme of recapitalisation. The current acceleration in credit delivery can be sustained in the medium term, if such fiscal support from States and Centre is firmly put in place while reviving or reorganising rural cooperative structure and RRBs, provided sound legal and policy frameworks are firmly put in place as a pre-condition. In the meantime, there is need to consider initiatives, as mutually agreed between the Reserve Bank and select States, to strengthen or revive, as appropriate, rural credit institutions while adhering to basic prudential requirements. Third, there is a need to foster credit culture to make enhanced rural credit a lasting phenomenon. Fourth, on the critical issue of risk mitigation, it is held that experiments with crop or credit insurance in India have not been very satisfactory so far. If some elements of insurance are ab initio not viable, extending credit becomes risky and hence constrained. Finally, there is merit in considering a comprehensive public policy on risk management in agriculture, not only as a means of relief for distressed farmers but as an ingredient for more efficient commercialised agriculture.

II.64 The programme of linking self-help groups with the banking system has emerged as the major micro-finance programme in the country. It is in this context that the Reserve Bank has been developing a congenial environment for non-governmental organisations engaged in micro-finance activities. Banks are being encouraged to adopt the agency model by using the infrastructure of civil society organisations, rural kiosks and village knowledge centres for providing credit support to rural and farm sectors and appointment of micro-finance institutions as banking correspondents.

II.65 The small scale industries sector plays a very important role in the development of the economy. The Reserve Bank is reviewing all its existing guidelines on financing small scale sector, debt restructuring, and nursing of sick units with a view to rationalising, consolidating and liberalising them. In view of the fast changing market conditions and increasing competitiveness, there is an urgent need to upgrade the technology of small scale industries and facilitate their graduation to the medium enterprise sector. A simplified debt restructuring and rehabilitation mechanism is being considered for the sector.

II.66 Although there has been expansion, greater competition and diversification of ownership of banks leading to both enhanced efficiency and systemic resilience in the banking sector, there are legitimate concerns in regard to the banking practices that tend to exclude rather than attract vast sections of population, in particular pensioners, self-employed and those employed in the unorganised sector. Against this background, the Reserve Bank will implement policies to encourage banks which provide extensive services while disincentivising those which are not responsive to the banking needs of the community, including the underprivileged. The nature, scope and cost of services will be monitored to assess whether there is any denial, implicit or explicit, of basic banking services to the common person.

II.67 Liberalisation and enhanced competition accord immense benefits, but experience has shown that consumers’ interests are not necessarily accorded full protection and their grievances are not properly attended to. Several representations are being received in regard to recent trends of levying unreasonably high ser vice/user charges and enhancement of user charges without proper and prior intimation. These issues have to be addressed keeping in view the merits of transparency, the need for avoidance of excessive charges and infirmities in contracts between vastly unequal parties.

II.68 In recent years, there has been some convergence in the conduct of monetary policy worldwide. Currently, there are striking similarities in the tools that monetary authorities employ to assess macroeconomic developments and the formation of expectations. The institutional architectures have begun to display several commonalities. The communication strategies and, thereby, public accountability are in the forefront in all central banks with progressively increasing globalisation of financial markets and emphasis on central bank autonomy. There is also greater universal recognition of the trade-offs confronting monetary policy decisions. At the same time, the challenges facing monetary authorities have become sharper. The heightened uncertainty surrounding the conduct of monetary policy has made interpretation of macroeconomic and financial data difficult. Uncertainty is more easily transmitted across the world than before through the ‘confidence’ channel, forcing the monetary authorities to contend with the contagion from shocks. Since the 1990s, considerations of financial stability have, therefore, assumed an increasing importance in monetary policy across the globe.

II.69 Notwithstanding these tendencies towards globalisation, the conduct of monetary policy continues to depend on country-specific factors such as the macroeconomic structure of the economy and its institutional setting, the degree of openness of the economy, the stage of development of financial markets, payment and settlement systems and the technological infrastructure. In India, although there is no explicit mandate for price stability, the conduct of monetary policy has evolved around the objectives of maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy for sustaining overall economic growth. The relative emphasis between price stability and growth has varied depending upon the underlying macroeconomic conditions. In essence, monetary policy in India strives for a judicious balance between price stability and growth. The democratic processes in India work in favour of price stability which, in some ways, amounts to an informal mandate to the central bank for maintaining an acceptable level of inflation. This framework has also been successful in ensuring financial stability in India through a decade and a half when frequent visits of financial crises led to debilitating losses in growth and welfare in large parts of the emerging market economies.

II.70 The conduct of monetary policy is getting increasingly sophisticated and forward looking, warranting a continuous upgradation of monitoring scan and technical skills. Flexibility and timeliness in policy response coupled with transparency and accountability hold the key to further enhancing credibility. Above all, the monetary authority has to address dilemmas which exert conflicting pulls at every stage. These issues have come to the fore in the conduct of monetary policy by the Reserve Bank in recent years. The Reserve Bank will continue to take necessary measures in response to the evolving situation to meet its price stability objective while maintaining financial stability and ensuring appropriate liquidity to meet credit growth and support investment and export demand in the economy.

II.71 With a view to further strengthening the consultative process in monetary policy, the Reserve Bank, in July 2005, set up a Technical Advisory Committee on Monetary Policy with external experts in the areas of monetary economics, central banking, financial markets and public finance. The Committee, which would meet at least once in a quarter, will review macroeconomic and monetary developments and advise the Reserve Bank on the stance of monetary policy. The views of the Advisory Committee would be discussed in the following meeting of the Committee of the Central Board (CCB) of the Reserve Bank. Concomitantly, the Reserve Bank decided that in addition to a Mid-term Review of the Annual Policy Statement in October, there will be a First Quarter Review of Part I of the Statement in July and a Third Quarter Review in January. The proposed quarterly reviews of monetary policy provide the opportunity for structured communication with markets on a more frequent basis while retaining the flexibility to take specific measures as the evolving circumstances warrant. The First Quarter Review – the first in the series – was released on July 26, 2005.

II.72 In sum, it is clear that prospects for economic growth are strong, while inflation has been contained so far. Maintaining macroeconomic and financial stability in an environment of sustained high growth of the economy in the future would, however, depend critically on policies relating to oil prices, diversification of agriculture, improvement in urban infrastructure, determined measures for fiscal consolidation and, above all, on the continuation of the positive investment climate in the country.