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HIGHLIGHTSOFRBISREPORTONMACROECONOMICDEVELOPMENTS [AlldataandpointshavebeentakenfromJan29RBIsmonetarypolicereview] Balanceofmacroeconomicriskssuggestsmonetarypolicyneedstobecalibratedinaddressinggrowthrisksas inflationturnssticky

Growthin201213islikelytofallbelowtheReserveBanksbaselineprojectionof5.8percent. InflationislikelytomoderatebelowtheReserveBanksbaselineprojectionof7.5percent.However, suppressedinflationcontinuestoposeasignificantrisktotheinflationin201314.Assomeoftherisks materialises,inflationpathmayturnsticky. Varioussurveysshowthatbusinessconfidenceremainssubdued.Surveyshowsthatforecastersoutsidethe ReserveBankanticipategrowthtorecoverfrom5.5percentin201213to6.5percentin201314.Average WPIinflationisexpectedtomoderatefrom7.5percentin201213to7.0percentin201314.

GLOBALECONOMICCONDITIONS Unconventionalmonetarypoliciesreducestress,butrisksremainahead

Fiscalrisksarelikelytokeepglobalrecoverymutedin2013.Whiletheimmediateriskofthefiscalcliffinthe UShasbeenaverted,riskstoglobalgrowthemanatingfromeuroarearemainsignificant.Therearesome signsofgrowthbottomingoutinEmergingMarketandDevelopingEconomies(EMDEs). Signsofstabilisationinglobaleconomicactivityhavebeeninevidenceinrecentmonths,ledbystronger thanexpectedgrowthintheUSinQ3,accelerationinthepaceofactivityinChinaandapickupinindustrial productioninEDEsinQ4.Activityintheeuroareacontinuestobeinacontractionmode,thoughfinancial marketconfidencehasimproved.JapanhasembarkedonafreshfiscalstimulusfollowingcontractioninQ3. IntheUK,amodestGDPgrowthinQ3wasfollowedbyadeclineinQ4.TheHSBCEmergingMarketIndex roseinQ4. Globalinflationscenariomaystaybenignasdemandinadvancedeconomies(AEs)remainsweak.Improved supplyprospectsincommoditieslikeoilandfoodarelikelytorestraincommoditypricepressures.However, upsideriskspersist,withpossiblerecoveryinEMDEsandlargequantitativeeasinginAEs.

INDIANECONOMY Output Growthslowdowncontinues,revivalmaytakesomemoretime

GrowthslowdowninIndiacontinueswithgrowthremainingbelowpotentialforthefifthsuccessivequarter. Policyinitiativesofthegovernmentareyettoshowupfullyordefinitivelyindata.Revivalmaytakesome moretime. Rabicropisexpectedtobenormaldespitedeficientrains,butisunlikelytofullycompensateforkharif deficiency.Sowingunderrabicrophasbeenbroadlythesameasthelevelinthepreviousyear. Page1

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Weakindustrialperformanceislikelytopersist.Subduedexternaldemandandlackofreliablepowersupply amidstcoalshortagesareconstrainingcapacityutilisation.LeadindicatorsofservicesectorandtheReserve BanksServiceSectorCompositeIndicatorsignalmoderation. TheReserveBanksOrderBooks,InventoryandCapacityUtilisationSurveyshowscapacityutilisation increasedmarginallyinQ2of201213.Onasequentialbasis,newordersmoderatedinQ2of201213. IndustrialactivityhasremainedsubduedandSluggishexternaldemandcontinuestoinhibitimprovementin services.Whilethecoverageofrabisowinghaspickedup,severewinterincertainpartshasendangered cropprospects.Newinvestmentdemand,whichshouldbethekeydriveroftheupturn,continuestobe weak.WhiletheseriesofpolicyinitiativesbytheGovernmenthasboostedmarketsentiment,itwilltake sometimetoreversetheinvestmentslowdownandreinvigorategrowth. Accordingly,thebaselineprojectionofGDPgrowthfor201213isreviseddownfrom5.8%to5.5%

AggregateDemand Improvementininvestmentclimateisaprerequisiteforeconomicrecovery

Demandconditionsremainedtepid,withprivateconsumptioncontinuingtodecelerateandwithinvestment yettorecover. InvestmentintentionsinnewprojectsimprovedmarginallyinQ2of201213,butinvestmentisheldbackby projectdelays.Coalsupplyissuesfacingpowersectorsareyettobefullyresolved.Roadinvestmentshave stalledduetoissuesrelatingtoenvironmentalclearances,landacquisitionandfinancialclosures. SalesgrowthmoderatedfurtherinQ2of201213toitslowestlevelinthreeyears,butnetprofitgrowth improvedmarkedly.EarlyresultsforQ3of201213indicatecontinuationofthetrendofsluggishsales. Qualityoffiscaladjustmentremainsaconcern,evenasfiscalriskshavereducedin201213.Governmentis workingtowardsachievingrevisedfiscaldeficittargetof5.3percentofGDPbyrestrictingbothplanand nonplanexpenditureduringthelastquarteroftheyear,evenassignificantshortfallintaxrevenueislikely. Increasedpublicinvestmenttocrowdinprivateinvestmentalongwithremovalofstructuralimpediments thatisslowingprivateinvestmentisneededtopulltheeconomyoutofthecurrentslowdown.

ExternalSector WideningofCADanditsfinancingremainsakeypolicychallenge

Wideningcurrentaccountdeficit(CAD)hasemergedasamajorconstraintineasingmonetarypolicy.With thelikelihoodthatCAD/GDPratiomayexceed4percentofGDPforthesecondsuccessiveyearin201213, prudenceisnecessarywhilestimulatingaggregatedemand. TheCAD/GDPratioreacheditshighesteverpeakof5.4percentofGDPinQ2of201213.Earlyindications arethatitmayincreasefurtherinQ3of201213.CADhaswidenedmainlyduetoworseningtradedeficit. ExportscontractedinDecemberfortheeighthmonthinsuccession,reflectingdepressedexternaldemand conditionsandstructuralbottlenecks.

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Ontheotherhand,importsroseonthebackofhigheroilandgoldimports,consequentlywideningthe merchandisetradedeficitinQ3comparedtoitslevelayearago. Ontopofthelargetradedeficit,theslowdowninnetexportsofservicesandlargeroutflowsofinvestment incomepaymentsisexpectedtowidenthecurrentaccountdeficit(CAD)furtherinQ3,beyondthelevelof 5.4percentofGDPrecordedinQ2of201213. StrongcapitalflowshavefacilitatedfinancingofCAD,resultingonlyinmarginaldrawdownofreserves. WhileincreasedFIIdebtinvestmentlimitsmayenhanceinflows,theydonotprovideasolutiontoCAD financingonasustainablebasis. Sofar,netcapitalflowshavebeensufficienttofinancetheCAD.Highernetinflowsofportfolioinvestment andaccretionstononresidentdepositscompensatedforlowernetexternalcommercialborrowingsand foreigndirectinvestment(FDI)intoIndia.Eventhoughnetcapitalflowshavebeenstrong,thesheersizeof theexternalfinancingrequirementimposedbythelargeCADhasbroughttobeardownwardpressureson therupeewhichdepreciatedinnominalandrealtermsbyJanuary2013relativetoitslevelinMarch2012. VariousmeasuresundertakenbytheGovernmentsincemidSeptember,includingliberalisationofFDIin retail,aviation,broadcastingandinsurance,defermentofgeneralantiavoidancerules(GAAR),reductionin withholdingtaxonoverseasborrowingsbydomesticcompaniesandsettingupoftheCabinetCommitteeon Investmenthavesignificantlyliftedmarketsentimentwhich,induecourse,shouldspurinvestment. Alongside,measuressuchasprogressivederegulationofadministeredfuelprices,withconcertedeffortsto adheretofiscaldisciplineandcarryforwardconsolidationcanpotentiallycorrectthetwindeficits.These policyactionscouldhelpengenderstablemacroeconomicconditionsandreturntheeconomytoitshigh growthtrajectory.Furtherreformstoraiseproductivity,improvecompetitivenessandmanagethesupply constraints,includingaugmentingenergyavailability,arecrucialforraisingthepotentialgrowthpathinthe mediumterm.

PriceSituation Headlineandcoreinflationmoderated,butsuppressedinflationposesrisks

HeadlineinflationmoderatedinQ3of201213withsignificantmoderationofcoreinflation,butCPI inflationedgeduptodoubledigits.Coreinflationpressuresareunlikelytoreemergequicklyon demandsideconsiderations. Headlinewholesalepriceindex(WPI)inflationeasedsignificantlyfrom8.1percentinSeptember2012 to7.2percentbyDecember.Notably,inflationonaccountofnonfoodmanufacturedproducts,which haveaweightof55percentintheWPI,fellsharplyinNovemberDecemberasinputpricepressures easedprimarilyonthebackofebbingmetal,nonmetallicmineralsandchemicalsgroupinflation. Foodinflation,ontheotherhand,showedacontrarianbehaviour,movingintodoubledigitsin December.Significantpricepressuresemanatedfromcereals.Pricesofpulsesandotherproteinbased fooditemsremainedelevated.Furthermore,withthefirmingupofpricesofedibleoilsandgrainmill products,theoverallmomentuminfoodinflationremainedfirm.

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Inflationbasedonthenewcombined(ruralandurban)consumerpriceindex(CPI)(Base:2010=100) roseto10.6percentinDecember,largelyreflectingthesurgeinfoodinflation.Excludingfoodandfuel groups,CPIinflationremainedunchangedat8.4percentduringQ3. Wageinflationremainsasourceofconcern.Ruralwageinflationdeclinedmarginallybutremainedhigh at18percent.Inorganisedmanufacturing,increasesinstaffcostsremainedindoubledigits. Goingforward,risksremainfromsuppressedinflation,pressureonfoodpricesandhighinflation expectationsgettingentrenchedintothewagepricespiral.Theinflationpathfor201314couldface downwardrigidity.

DECISIONSANNOUNCED: Reducethepolicyreporateby25basispointsfrom8.0percentto7.75percent Consequenttothis,thereversereporate,determinedwithaspreadof100basispointsbelowthereporate, getscalibratedto6.75percent.Similarly,themarginalstandingfacility(MSF)rate,determinedwitha spreadof100basispointsabovethereporate,andalsotheBankRatestandadjustedto8.75percent. Decidedtoreducethecashreserveratio(CRR)ofscheduledbanksby25basispointsfrom4.25percentto 4.0percentoftheirnetdemandandtimeliabilities(NDTL).ThisreductionintheCRRwillinjectprimary liquidityofaroundRs.180billionintothebankingsystem.

ConsiderationsBehindthePolicyMove 1. First,bothheadlinewholesalepriceinflationanditscorecomponent,nonfoodmanufacturedproducts inflation,havesoftenedthroughthethirdquarter.Thisprovidedsomerelieffromthepersistencethat dominatedthefirsthalfoftheyear.Severalindicatorssuchastheweakerpricingpowerofcorporates, excesscapacityinsomesectors,thepossibilityofinternationalcommoditypricesstabilisingaswellas inflationmomentummeasuressuggestthatinflationarypressureshavepeaked.However,further moderationininflationgoingintothenextfiscalyearislikelytobemutedasthecorrectionofunderpricing ofadministereditemsisstillincompleteandfoodinflationremainselevated.Accordingly,thesettingof monetarypolicyhastoremainsensitivetotheseconflictingpressuresandattendantrisks. 2. Second,growthhasdeceleratedsignificantlybelowtrendthroughthelastfiscalyearandthroughthisyear sofar,andoveralleconomicactivityremainssubdued. a. Onthedemandside,investmentactivityhasbeenwaybelowdesiredlevelsandconsumption demandtoohasstartedtodecelerate.Externaldemandhasalsoweakenedduetolanguidglobal growth. b. Onthesupplyside,constraintsintheavailabilityofkeyrawmaterialsandintermediatesare becomingbinding. c. WhiletheseriesofpolicymeasuresannouncedbytheGovernmenthasboostedmarketsentiment, theinvestmentoutlookisstilllacklustre,especiallyintermsofdemandfornewprojects. 3. Thethirdconsiderationthatinformedourdecisionisthatliquidityconditionshaveremainedtight.This tightnesscouldpotentiallyhurtcreditflowtoproductivesectorsoftheeconomy. EssaysforIIM.com200913 Page4

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RiskFactors Macroeconomicmanagementgoingforwardissubjecttoanumberofrisksasindicatedbelow: i) Domestically,thewideningoftheCADtohistoricallyhighlevelsinthecontextofalargefiscaldeficitand slowinggrowthexposestheeconomytotherisksfromtwindeficits.FinancingtheCADwithincreasingly riskyandvolatileflowsincreasestheeconomysvulnerabilitytosuddenshiftsinriskappetiteand liquiditypreference,potentiallythreateningmacroeconomicandexchangeratestability.Largefiscal deficitswillaccentuatetheCADrisk,furthercrowdoutprivateinvestmentandstuntgrowthimpulses. Globalrisksremainelevated,withthepotentialforspilloversontheIndianeconomythroughtrade, financeandconfidencechannels.IntheUS,theriskofpoliticalinactiontomanagethedebtceilingor evenasuddenonsetoffiscalausteritycanleadtoturmoilinfinancialmarkets,followedbyadownturn ineconomicactivity.Escalationoftheeuroareasovereigndebtstressinviewofthecontinuingabsence ofcredibleandcomprehensivepolicyresponsesremainsacontingentglobalrisk,alongwithgeopolitical tensionsthatcanadverselyimpactsupplies/pricesofkeycommodities,particularlyofcrudeoil.These forcescanpotentiallyincreaseglobalriskaversionwithimplicationsforfinancingoftheCAD. Inflationoverthelastthreeyearshasbeenaresultofdemandpressuresaswellassupplyconstraints. Withdemandpressuresnowontheebb,thesupplyconstraintsneedtobeurgentlyaddressed.Thiswill requiredevelopinganadequate,credibleandflexiblesupplyresponseinrespectofthosecommodities andsegmentsoftheeconomycharacterisedbystructuralimbalances.Intheabsenceofaneffective supplyresponse,inflationarypressuresmayreturnandpersistwithadverseimplicationsfor macroeconomicstability. Thekeytostimulatinggrowthisavigorousandsustainedrevivalininvestment.Achievingthiswill, however,dependonanumberoffactorssuchasbridgingtheinfrastructuregaps,especiallyinpower andtransport,hasteningapprovals,removingproceduralbottlenecks,andimprovinggovernance. Riskaversioninthebankingsystemstemmingfromconcernsrelatingtoassetqualityisconstraining creditflow.Notwithstandingtheimportanceofrepairingassetquality,banksshouldbediscerningin theirloandecisionsandensureadequatecreditflowtoproductivesectorsoftheeconomy.

ii)

iii)

iv)

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