Assessment of Macroeconomic and Monetary Developments during the First Half of 2006-07
Overall Assessment44. In the Indian economy, aggregate supply conditions appear to have strengthened in the first half of 2006-07, invigorated by the pick-up in activity in all constituent sectors of the economy. While growth in agriculture in the first quarter seems to have benefited mainly from the rabi season of 2005-06 (which came to a close in June 2006), the prospects for agriculture in the rest of 2006-07 seem to have improved. Hence, a resumption of trend growth in agriculture appears realisable for the current year, despite some setbacks on account of floods in various parts of the country and somewhat deficient rainfall in foodgrains growing areas. 45. Industrial production appears to be performing better than consensus expectations, propelled by growth in manufacturing which touched a ten-year high in April-August, 2006. The industrial climate is characterised by buoyant corporate sales/profitability and record tax collections. This is supported by the strength of domestic and export demand, resilient business confidence and improvement in financing conditions, particularly in sustained growth in bank credit. The momentum of industrial activity, if sustained, is likely to impart an upside bias to expectations of overall macroeconomic performance. 46. Lead indicators point to continued bright prospects for growth in services. There has been a sustained improvement in railway revenue earnings in freight traffic and in import/export cargo handled by civil aviation. Foreign tourist arrivals as well as passengers handled at domestic air terminals have recorded increases during the first half of 2006-07. Furthermore, there has been a noticeable addition to switching capacity under both telephone and cell phone connections. Accordingly, all sub-sectors under services, which account for about 70 per cent of overall GDP growth, display dynamism. 47. Turning to aggregate demand conditions, there seems to be some evidence of pressures firming up in the form of high growth in capital goods output, an upturn in investment in infrastructure and a quickening of the capital expenditure cycle. There are indications that strengthening investment demand is beginning to drive the economy. More importantly, consumption demand, which accounts for over two-thirds of aggregate domestic demand, also seems to be gathering strength. This is evident from high retail credit and double-digit growth in the production of consumer durables in the first five months of 2006-07. Consumer non-durables have shed their earlier sluggishness and picked up in July and August. Demand pressures are also visible in the expansion of money supply and reserve money which has been sizeably higher than anticipated. 48. The demand for bank credit has been growing at above 30 per cent for the third year in succession. Available information points to high growth in credit extended by banks to fast growing sectors such as housing, commercial real estate and retail loans. Asset prices remain at elevated levels and current levels of commodity prices make an overall assessment a complex task. 49. Against this background, it is critical to be watchful for early signs of overheating. An overheating economy is one which is growing rapidly and its productive capacity cannot keep up with resulting demand pressures. Emergence of inflationary pressures is usually seen as the first indication of overheating. In this context, policy makers keenly analyse the behaviour of the output gap, i.e., the excess of current output over potential or full capacity output. In the context of setting monetary policy, judging how close an economy is to operating at full capacity is crucial. If the monetary authority senses that there is unutilised capacity, the increase in demand generated by growth can be accommodated without inflationary pressures and, therefore, the need to act against overheating may not arise. On the other hand, if demand is running ahead of full capacity, there is a case for tightening of monetary policy with a view to slowing down the economy and heading off overheating. 50. Globally, there seems to be increasing difficulty in identifying the symptoms of overheating. There is some evidence of a blurring of the relationship between output gaps and inflation. Moreover, the size and direction of an economy’s potential output is becoming increasingly difficult to diagnose. In particular, globalisation has expanded the supply potential of various economies, especially emerging economies. In the recent period, it appears that the current positive supply shock has made the concept of potential output fuzzier than in the past. For a developing economy like India, the concept of overheating is less of a guide for monetary policy than in advanced economies on account of the existence of large unemployment/underemployment of resources and the absence of a clear assessment of potential output. Furthermore, it is difficult to obtain a clear judgement of potential output in an economy that is undergoing structural transformation. Nevertheless, recent developments, in particular, the combination of high growth and consumer inflation coupled with escalating asset prices and tightening infrastructural bottlenecks underscore the need to reckon with dangers of overheating and the implications for the timing and direction of monetary policy setting. While there is no conclusive evidence of overheating in the Indian economy at the current juncture, the criticality of monitoring all available indications that point to excess aggregate demand is perhaps more relevant now than ever before. 51. Monetary policy operates with lags that can be long and variable, depending on the specifics of the country situation. It is in this context that the setting of monetary policy is required to be forward looking with the full impact of current policy actions coming into play 12 to 18 months later. In India, the key policy signalling rates embodied in the LAF repo/reverse repo rates have been raised since October, 2004 by a cumulative 100/150 basis points, supported by a 50 basis points increase in the CRR. This calibrated withdrawal of accommodation is in the process of working itself through the various sectors of the economy. Hence, in addition to current signs of demand pressures, the evolution of demand conditions in the next few months is critical for considering the possible emergence of overheating, if any, with concurrent implications for both price and financial stability. 52. In the domestic financial markets, there seems to be some evidence of moderation in volatility in the second quarter of 2006-07 within an overall re-pricing of risks. Money markets continue to be characterised by conditions of excess liquidity, interrupted by brief spells of temporary tightness in the second half of September on account of advance direct tax outflows and balance sheet requirements. Short-term rates have generally evolved in alignment with policy rates and have responded favourably to the policy stance in June and July. In the foreign exchange market, the exchange rate of the rupee has exhibited two-way movements. Since end-July, however, the market sentiment has turned upbeat, mirrored in a modest nominal appreciation. In the Government securities market, yields have come off mid-July highs and have corrected substantially. 53. Inflationary pressures, as exhibited in wholesale and consumer prices warrant continued special focus. Despite recent easing, it will be prudent to presume that oil prices at current levels may still contain some elements of a ‘permanent’ component which is yet to be matched by full pass-through. Hence, the possible risks for inflation in the months ahead need to be viewed against this background. It is desirable to watch for incipient pressures building up on prices of manufactures with the quickening of domestic industrial activity and the elevated levels of international commodity prices. It is also necessary to monitor the seasonal movements in prices of food articles in the remaining part of the year, given their criticality for inflation perceptions and consequently, inflation expectations. In the months ahead, it is difficult to assess whether productivity gains and competitive conditions will be able to head off the squeeze on margins that seems to be setting in. Furthermore, it is possible to hold that positive base effects that have couched the impact of upside pressures on price changes so far would wear off and this could amplify measured inflation towards the close of 2006-07. 54. Fiscal spending has picked up in the first five months of 2006-07 and the Centre’s gross fiscal deficit has been running higher on an annual basis in relation to budget estimates. The buoyancy in tax revenues may, however, mitigate the expansionary impact if it gets entrenched in the remaining months of the year. Consumer prices for all categories have been rising through the first half of 2006-07, reflecting the impact of heightened primary product prices, including those of essential commodities. The wedge between consumer prices and wholesale prices remains larger than before. While a combination of fiscal and monetary measures seems to have reinforced each other and helped to mitigate the inflationary risks, there are reasons to be vigilant on this front. In particular, looking ahead, it may be appropriate to hold that the outlook for inflation in India is more likely to be driven by demand conditions rather than by the strong positive supply-side effects noticed in the recent past. 55. In an economy-wide sense, the faster growth of aggregate demand relative to aggregate supply during 2006-07 has begun to be manifested, to some extent, in the external sector. The merchandise trade deficit and the current account deficit have expanded despite buoyant export growth and some moderation in the growth of non-oil imports. So far, the high prices of international crude seem to have been driving the widening of the trade deficit. Softening of these prices in the months ahead could offset such pressures. Merchandise export growth has remained reasonably strong. Gross invisible earnings have expanded rapidly in recent years and are poised to equal merchandise exports. Fast growth in earnings from travel, software and other business service exports has complemented the stable support from inward remittances which is being increasingly regarded as a ‘permanent’ component of India’s external balance sheet. Capital flows seem to have recovered from the turbulence of May-June and have resumed strongly with debt flows in April-June, 2006 increasing to US $ 5.2 billion from US 1.0 billion a year ago. On the whole, it is reasonable to expect that, as in the recent past, capital flows will enable financing of the current account deficit and some continuing accretion to the level of foreign exchange reserves. 56. In recent months, there are some indications of a shift in the patterns of global growth. First, the US economy, which has powered the recent phase of global expansion, seems to be beginning to slow, driven down primarily by the contracting housing market. Second, activity appears to have gathered momentum in the Euro area and Japan but it is unclear as to whether or not this recovery is self-sustained. Third, the onus for sustaining global growth seems to be shifting to the emerging economies, particularly low per capita income countries. Financial upheavals right up to May-June this year are a reminder that market conditions in emerging economies have been relatively volatile in response to exogenous developments. Fourth, shifts in the pattern of international trade are also discernible. China’s rising importance has been paralleled by a reduced reliance of major emerging economies on the US as an important export destination. 57. Globally, inflation risks remain, though incipient at the current juncture. While headline inflation rates are moderating, core inflation, especially in the US, has remained firm, indicating that upside pressures from oil and commodity prices persist across advanced and emerging economies, especially at the producer level. Potential risks from the possible full indirect effects of elevated and uncertain oil/commodity prices, some possible tightening of global production capacities and the remaining overhang of global liquidity continue to weigh upon the setting of monetary policy worldwide. There are also signs of wage pressures setting in. While some deceleration in economic activity in recent months seems to have induced a pause in the policy tightening cycle of several important central banks, the persistent threats of inflation constrain monetary authorities from possible moves towards a more neutral stance in an aggressive fashion. 58. Global imbalances have continued to widen during 2006. With some central banks actively reassessing their stance now, the potential drainage of global liquidity would test the resilience of world financial markets and weigh upon the outlook on the global economy. Globally, the concerns are not about the existence of current account deficits or surpluses per se, but the persistence of large deficits and surpluses, particularly in large and systemically important economies. It is in this context that the IMF’s projection of the U.S. current account deficit at about 7 per cent of GDP in 2007 with large surpluses continuing in Japan, emerging Asia and oil-exporting countries is disturbing. The sharp rise in the net foreign liability position of the US raises the risks of abrupt and disorderly adjustment of major currencies as the global imbalances unwind. However, there is an interesting lull in the serious concerns expressed both by policy makers and financial markets in regard to the global imbalances, possibly on the assumption that universal recognition of the problem would per se lead to harmonised actions that would avoid hard landing. 59. Global financial markets have revised expectations in response to the changes in the magnitude and pace of monetary tightening between June and September, 2006. In the money markets, there appear to be widening expectations that, at best, interest rates are expected to rise only gradually from now on. On the other hand, these revisions in expectations have coincided with falling long-term interest rates in the US, the Euro area and Japan leading to inversion/flattening of yield curves. Global equity markets have recovered some of the losses suffered in May and June with those markets that recorded the largest losses gaining the most. Spreads in corporate credit markets have remained tight, broadly unchanged from late June. A boom in global mergers and acquisitions has been underway and has been financed, to some extent, by increased leverage. Changes in expected short-term interest rate differentials have emerged as important drivers of foreign exchange markets, enabling a moderate strengthening of the euro. The yen’s role as a funding currency for carry trades remains significant. The pound sterling has strengthened in the wake of the increase in the policy rate by the Bank of England. Currencies of emerging economies have benefited from a reversal of May-June portfolio outflows. Renewed strength in commodity prices has also played a role in foreign exchange markets. Nevertheless, geopolitical risks remain a key factor in determining the evolution of major currency movements. It is also important to recognise the potential risks emanating from the possible moderation of liquidity and oil surpluses on account of the impact of monetary policy action as well as the likelihood of the ebbing of oil prices. 60. Credit markets, particularly in developing countries, have been experiencing heightened activity since 2004. During 2006, there seems to be growing evidence that a synchronised upswing in bank credit is taking hold across emerging economies in Asia and Latin America in an environment of strong growth and excess liquidity in banking systems. This recent surge is accompanied by compositional shifts on the assets side of banks’ portfolios. Households, not corporates – historically the most important borrowers from banks – have absorbed a significant portion of the credit growth. There seem to be some risks to sustainability of the recent rapid pace of bank credit growth to households. First, households could become overextended as reflected in credit card busts in several emerging economies. Second, large accumulation of debt could leave households prone to future interest rate/exchange rate shocks since banks have, in effect, transferred a large part of their market risks to households. Third, excessive reliance on debt-financed consumption could turn out to be a serious problem if refinancing options dry up. Fourth, moral hazard and adverse selection is a constant challenge facing banks. Fifth, housing markets continue to remain overheated and, therefore, a source of risk. 61. In the overall assessment, while global growth has been strong and broad-based, there seem to be some indications of moderation in recent months. There are also perceptions of risks to growth from the cooling of the housing market in the US and the potential drainage of liquidity from financial markets. While global inflation conditions have not worsened, concerns relating to potential price pressures persist, particularly in the context of the firming up of food and metal prices, the uncertainty surrounding international crude prices and the monetary overhang. While geopolitical risks continue to cast a shadow, it is necessary to recognise that global risks have not changed significantly from the time of the First Quarter Review of July, 2006. Domestic developments exhibit strength and resilience with some downside risks. There is a pick-up in the momentum of growth which also appears to be spreading across all constituent sectors of the economy. Domestic financial markets have exhibited stable and orderly conditions. In the external sector, there are signs of abiding strength and the current account deficit has been well-managed so far. On the other hand, there are indications of growing demand pressures and potential risks from rapid credit growth and strains on credit quality. High levels of monetary expansion and the evolution of the liquidity situation will need to be continuously monitored for any signs of risks to inflation. The elevated levels of asset prices also represent a risk to the outlook for macroeconomic and financial stability. In brief, at the current juncture, for policy purposes, the two major issues that exert conflicting pulls are exploration of signs of overheating firming up to warrant a policy response, and, the impact of lagged effects of earlier policy action on the evolution of macroeconomic developments.