1. During the course of 2013-14, monetary
policy had to face an extraordinary spell of
financial turbulence arising from the US Fed
contemplating tapering its large scale asset
purchase programme. The news heralded the
turning of the global interest rate cycle with
volatile movements for cross-border capital
flows and asset prices. Like most emerging
market and developing economies (EMDEs),
India faced capital outflows and intense
exchange rate pressures. Monetary policy had
to depart from its charted course of calibrated
monetary easing that had started in April 2012
using the monetary policy space that was
gradually becoming available. Past monetary
tightening was dampening the pricing power of
the corporates and the return to fiscal
consolidation in H2 of 2012-13 was reducing
the twin deficit risks. Though macroeconomic
weaknesses were evident in the form of
persistence in inflation, falling growth, weaker
corporate balance sheet, deteriorating asset
quality of the banks, fiscal imbalances and
external sector vulnerabilities, the economy
seemed to be mending. However, the prospect
of tapering interrupted this.
2. The event resulted in a rapid
deterioration of financial conditions across
emerging markets, including India. The rupee
exchange rate depreciated by 17 per cent
against the US dollar, amid a foreign exchange
reserve depletion of nearly US$17 billion, between the first indication of tapering and
September 3, 2013. There were net FII
disinvestments of over US$13.4 billion (US$10.5
billion in debt and US$2.8 billion in equity) over
this period. Large capital outflows and sliding
currency brought to fore the underlying macroeconomic
weaknesses. Stabilisation of the
economy by restoring exchange rate stability
became the overriding task.
3. Short-term interest rates were raised
by hiking the Marginal Standing Facility (MSF)
rate by 200 bps and siphoning off excess
liquidity with a view to defending the rupee
exchange rate. Several other measures were
introduced, either to restrain the current
account deficit (CAD) or to improve its
financing. These policies, along with a forward-looking
blueprint for further financial market
reforms laid down by the Reserve Bank on
September 4, helped turn the tide and stabilise
financial market conditions. Since that point,
rupee has appreciated 6.7 per cent (till January,
27, 2014) against the US dollar and the reserve
loss has been more than fully recouped. Capital
flows resumed, with net investment of US$9.1
billion in equities during September 4, 2013 to
January 24, 2014. Though there were large
disinvestments in the debt segment aggregating
US$ 14.5 billion from May 22 to end-November
2013, debt flows have turned positive thereafter
with net investments of US$ 3.8 billion. More
importantly, the looming external sector risks were mitigated with CAD shrinking from 4.9
per cent in Q1 of 2013-14 to 1.2 per cent of
GDP in Q2. With the resultant improved
stability in the foreign exchange market, the
Reserve Bank quickly moved to normalise
exceptional liquidity and monetary measures
and recalibrate monetary policy, taking into
account, the prevailing inflation and growth
conditions. The MSF rate was lowered by 150
bps in three steps, while the repo rate was raised
by 50 bps in two steps. Besides liquidity
conditions were eased to realign operational
policy rate to the repo rate that is now 25 bps
higher than at the start of the year. The Reserve
Bank has maintained a tight monetary policy
stance but has desisted from stiff tightening
keeping in mind the weak state of economy. It
has been evolving its policy action with rapidly
changing financial and macroeconomic
conditions.
4. This Report explains the recent policy
actions and provides a macroeconomic backdrop
to global and domestic economic conditions that
have gone into formulating the monetary policy
response to the third quarter review. The
highlights of the report are the following:
Global Economic Conditions
Global growth prospects improve, though
downside risk still exist
5. Global growth, after decelerating for
the last three years is poised to improve in 2014,
but risks to outlook remain with uncertainties
arising from moves to unwind unconventional
monetary policies and possibility of a renewed
deflation in the euro area. Economic expansion
in the US is gaining firmer footing and will aid
recovery in global activity and trade. Recovery
in large EMDEs could stay moderate as supply-side
constraints, tight monetary policies and
tightening of financial conditions with tapering by the US could act as a drag on growth
acceleration.
6. Inflation has continued to be low in
advanced economies (AEs) aided by high
unemployment and large spare capacities. After
a year of deflation, inflation picked up in Japan.
Among the emerging economies, monetary
policy was tightened further by Indonesia, India,
and Brazil, as they confronted high inflation and
pressures on their exchange rates. Going
forward, inflation risks for EMDEs are likely to
stay in the near-term conditioned by structural
factors and demand pressures emanating from
narrowing output gap. However, global
commodity price cycle is likely to stay benign
on the back of improved supplies of oil, metals
and food.
7. The US Fed’s announcement on
December 18 of tapering of its large scale asset
purchase programme had a limited impact on
global financial markets in sharp contrast to
the May indication. India, having rebuilt its
buffers during Q3, withstood the announcement
better than many of its peers. Going forward,
the spacing of the Fed’s tapering moves over
the course of 2014 could influence market
movements even though some of it seems to have
been priced in.
Indian Economy: Developments and Outlook
Output
Growth may improve a tad in H2 of 2013-14
due to rebound in agriculture and improved
exports
8. Growth in H2 of 2013-14 may turn out
to be marginally higher than H1, mainly due to
a rebound in agriculture output and improved
export performance. However, industrial growth
continues to stagnate and leading indicators of
the services sector exhibit a mixed picture. Clear signs of a pickup are yet to emerge,
though a modest recovery is likely to shape up
in 2014-15. Durable recovery remains
contingent on addressing persistent inflation,
and the bottlenecks facing the mining and
infrastructure sectors.
Aggregate Demand
Aggregate demand slowly picking up, but
would require support through public
investment to crowd-in private investment
9. Aggregate demand in the economy
exhibited some improvements during Q2 of
2013-14 mainly on account of surge in net
exports. However, private consumption
expenditure, the mainstay of aggregate demand
stayed low in the face of high inflation that has
caused discretionary demand to fall. The
investment cycle is yet to turnaround. However,
corporate sales have improved during Q2,
indicating that demand may have started
improving. Overall, aggregate demand is
expected to receive support from rural demand
and exports, though downside risks emanate
from public spending cuts. The pick-up in
demand in the coming year depends critically
on the successful resolution of bottlenecks
facing infrastructure and energy-intensive
industrial projects. It is also important to create
fiscal space in 2014-15 to support public
investment by restraining revenue spending, so
as to crowd in private investment. As such the
quality of government spending has to improve
to support growth.
External sector
Lower trade deficit in Q2 and Q3 of 2013-14
brings CAD to sustainable levels
10. In response to the adjustment of the
rupee exchange rate, disincentivising on gold
imports, as also improvement in global trade, India’s trade deficit during April-December
2013 has been 25 per cent lower than last year.
Consequent to lower trade deficit, CAD
declined from 4.9 per cent of GDP in Q1 to 1.2
per cent of GDP in Q2 of 2013-14 and the full
year CAD is likely to be below 2.5 per cent of
GDP. This, along with recouping the reserve
loss due to the Reserve Bank’s swap windows
helped mitigate external sector risks. However,
as capital flows to EMDEs could moderate
over 2014-15, there is no scope for complacency
and the breather provided by a reduction in
the immediate risks, needs to be used to
develop the resilience of the external sector
over the medium-term.
Monetary and Liquidity Conditions
Monetary policy evolving with changing
macro-financial conditions
11. Large capital outflows and consequent
exchange rate pressures since May changed the
course of monetary policy. Short-term interest
rates were raised and liquidity conditions were
tightened considerably through exceptional
measures till such time as the exchange rate
stabilised. Since then the exceptional measures
have been normalised, though resurgence in
inflation prompted policy rate increases. Also,
additional liquidity was provided through term
repos and forex swaps. The latter added to net
foreign assets (NFAs) and turned out to be a
significant driver of reserve money growth in
Q3 of 2013-14.
Financial Markets
Normalcy restored in financial markets but
political outcomes and commitment to reforms
hold the key
12. Normalcy was restored in both global
and domestic financial markets after the May
tapering indications abruptly tightened financial conditions. Due to rebuilding of buffers, the
Indian financial markets successfully withstood
the effect of the Fed’s tapering decision in
December 2013. In fact, equity markets gained
by over 9 per cent during Q3 as markets priced
in macroeconomic improvement arising mainly
from lower external sector risks and better-than-expected
corporate results. However, primary
capital markets remained subdued. While global
investors had turned overweight on Indian
equities in the 2014 asset allocations, the
performance of markets in the near term will
be conditioned by political risks and commitment
to reforms.
Price Situation
Inflation declines significantly on vegetable
price correction but CPI ex-food and fuel
inflation exhibits persistence
13. Inflation declined significantly in
December 2013, both in terms of the CPI and
WPI, driven by falling food prices which had
firmed up considerably during April-November.
Despite the moderation, CPI inflation continued
to remain high near 10 per cent with inflation
excluding food and fuel components also
remaining persistent at 8.0 per cent. Earlier, the
path of disinflation was disrupted by a series of
food price shocks during June-November and
a weaker rupee. Food price pressures reflect
rising input costs, including higher agriculture
wages, output shortfalls and uncompetitive
supply chains. Non-food manufactured products
WPI inflation has remained subdued so far in
the presence of a negative output gap, though it has increased recently due to cost-push
pressures. These pressures, along with second round
impacts, have also caused consumer price
inflation, ex-food and fuel to remain persistently
high.
Macroeconomic Outlook
Gradual recovery likely in 2014-15; risks to
inflation stay despite some moderation
14. Various surveys, including the Reserve
Bank’s Industrial Outlook Survey, show that
business confidence has started to rebuild. On
current reckoning, growth in 2013-14 is likely
to fall somewhat short of the Reserve Bank’s
earlier projection of 5.0 per cent. However, a
moderate paced recovery is likely to shape in
the next year with support from rural demand,
a pick-up in exports and some turnaround in
investment demand. The growth in 2014-15 is
likely to be in the range of 5 to 6 per cent, with
likelihood of it being in higher reaches of this
forecast range as project clearances translate
into investment, global growth outlook improves,
and inflation softens. Despite moderation in
December and some further softening expected
in near term, inflation risks have to be watched
carefully as we enter into the next year. This is
due to upward revision in domestic energy
prices, expected growth acceleration, structural
bottlenecks affecting food inflation and adverse
base effects. Headline CPI inflation is expected
to remain above 9 per cent in Q4 of 2013-14
and range between 7.5 to 8.5 per cent in Q4 of
2014-15, with the balance of risks tilted on the
upside.
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