m1 Monetary Policy Reserve Bank of India

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TABLE OF CONTENTS

ABSTRACT II

Chapter No. Contents Page No.

1 INTRODUCTION 4

2 THE IMPACT OF MONETARY POLICY 8

3 POLITICAL IMPLICATIONS OF INDIAS ECONOMIC

SLOWDOWN

20

4 DEVELOPMENTS OF FINANCIAL MARKETS AND

INTEREST RATE

24

5

6

INDIAN ECONOMY: OUTLOOK AND PROSPECTS: FY12

AND FY13

28

INTEREST RATE HIKE WILL HURT GROWTH, FEARS

FICCI

37

7 INDIA LOOSENS MONETARY POLICY 38

8 CONCLUSION:

SHOULD THE RBI HAVE AN 'EASY' OR 'TIGHT'

MONETARY POLICY?

39


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ABSTRACT

Monetary policy is the process by which monetary authority of a country, generally a central

bank controls the supply of money in the economy by exercising its control over interest rates in

order to maintain price stability and achieve high economic growth.[1]

In India, the centralmonetary authority is the Reserve Bank of India (RBI). is so designed as to maintain the price

stability in the economy. Other objectives of the monetary policy of India, as stated by RBI, are:

Price Stability

Price Stability implies promoting economic development with considerable emphasis on price

stability. The centre of focus is to facilitate the environment which is favorable to the

architecture that enables the developmental projects to run swiftly while also maintaining

reasonable price stability.

Controlled Expansion Of Bank Credit

One of the important functions of RBI is the controlled expansion of bank credit and money

supply with special attention to seasonal requirement for credit without affecting the output.

Promotion of Fixed Investment

The aim here is to increase the productivity of investment by restraining non essential fixed

investment.

Restriction of Inventories

Overfilling of stocks and products becoming outdated due to excess of stock often results is

sickness of the unit. To avoid this problem the central monetary authority carries out this

essential function of restricting the inventories. The main objective of this policy is to avoidover-stocking and idle money in the organization

Promotion of Exports and Food Procurement Operations
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Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an

independent objective of monetary policy.

Desired Distribution of Credit

Monetary authority has control over the decisions regarding the allocation of credit to priority

sector and small borrowers. This policy decides over the specified percentage of credit that is to

be allocated to priority sector and small borrowers.

Equitable Distribution of Credit

The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all

social and economic class of people

To Promote Efficiency

It is another essential aspect where the central banks pay a lot of attention. It tries to increase the

efficiency in the financial system and tries to incorporate structural changes such as deregulating

interest rates, ease operational constraints in the credit delivery system, to introduce new money

market instruments etc.

Reducing the Rigidity

RBI tries to bring about the flexibilities in the operations which provide a considerable

autonomy. It encourages more competitive environment and diversification. It maintains its

control over financial system whenever and wherever necessary to maintain the discipline and

prudence in operations of the financial system.


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INTRODUCTION

A policy employing the central banks control of the supply of money as an instrument for

achieving the objectives of general economic policy is a monetarypolicy.

Monetary policy, also known as Credit Policy, helps RBI in deciding about the supply of

money in an economy, ratio ofinterest to be charged for some amount of money. It provides

measure to control inflation and most important of all it helps in deciding how to achieve the

economic growth and development objectives of an economy.

So to attain these objectives various monetary policy instruments are used.

Monetary Policy Instruments

Principal Instruments of monetary policy or credit control are broadly classified as:

Quantitative Instruments: These tools are related to the Quantity or Volume of the money.These are the instruments of monetary policy which affect overall supply of money/ credit in

the economy. For example, Bank Rate, Cash Reserve Ratio.

Qualitative Instruments: These instruments direct or restrict the flow of credit to specifiedareas of economic activity. These include instruments like Margin Requirement, Direct

Auction etc. It may be possible that some qualitative instruments may have shades of

quantitative instrument.

We will limit our scope to various quantitative instruments for this discussion. We will definitely

take it forward in the coming posts.

Bank Rate: The interest rate at which RBI lends money to the commercialbanks.

Managing the bank rate is a preferred method by which central banks can regulate the level of

economic activity. In most of the cases, the increase (or decrease) in bank rate is often followed

by increase (or decrease) in market rate of interest.

But how is this helping in controlling the credits in an economy. Lets have a look.With the increase in the bank rate by RBI, commercial banks reduce their volume of borrowings

from RBI as high bank rate increases their cost of borrowing. Thus, they have less availability of

credit with them to lend to public or if they have, it is available at high rate. Therefore, with

increase in bank rate there is an increase in market rate of interest also and this ultimately

results in reduced borrowing by public.


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On the other hand, if the RBI reduces the bank rate, borrowings for commercial banks will

become cheaper. And banks will also reduce their rates thus resulting in credit expansion.

Open Market Operations (OMO): The open market operation refers to the purchase and/or

sale of short term and long term securities by the RBI in the open market.Lets see how it helps

in credit control.

RBI, especially during inflation, sells government securities in an open market which is

purchased by commercial banks and private individuals. When commercial banks purchases

securities, money get transferred to RBI from commercial bank. Thus, there is fall in money

supply in an economy. Now due to decrease of money supply, purchasing power reduces which

helps in controlling inflation.

While, when RBI buys the securities from commercial banks in the open market, commercial

banks sell securities and get back the money. It results in increase in the volume of money in the

economy. It is done mostly during depression or recession.

Variable Reserve Rates (VRR): These basically include Cash Reserve Ratio (CRR) and

Statutory Liquidity Ratio (SLR).

CRR: Cash reserve ratio is the cash parked by the banks in their specified current accountmaintained with RBI.

Commercial banks have to keep a certain percentage of their total deposits in the form of cash

reserves with RBI. For example if CRR is 10% and total deposits with a bank are Rs. 100 crore,they will have to keep Rs. 10 crore with RBI as minimum cash reserves.

SLR: Statutory liquidity ratio is in the form of cash (book value), gold (current marketvalue) and balances in unencumbered approved securities.


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Every bank is required to maintain a fixed percentage of its assets in the form of cash and other

liquid assets with RBI.

Otherliquid assets include cash, balances with RBI, balances in current accounts with banks,

money at call and short notice, inter-bank placements due within 30 days and securities under

held for trading and available forsale categories excluding securities that do not have

ready market.

All said and done but how does it helps in controlling money supply?

By varying VRR commercial banks lending capacity can be affected. Suppose, commercial banks

have total deposits of 100 crore with them. Now if VRR increases from 20% to 30%, than the

reserves to be held by banks would increase from 20 crore to 30 crore.

Thus, the availability of money with commercial bank which can be used for credit creation will

reduce by 10 crore. On the contrary any decrease in VRR will make more money available with

banks for credit creation.

Liquidity Adjustment Facility: A tool used in monetary policy that allows banks to borrow

money through repurchase agreements.

But what is repurchase agreement or Repo?

Repo or ready forward contact is an instrument for borrowing funds by selling securities with

an agreement to repurchase the said securities on a mutually agreed future date at an agreed

price which includes interest for the funds borrowed.

Thus, in Repo transaction banks borrow funds from RBI by selling securities with

anagreement to repurchase the said securities on a mutually agreed future date at an agreed

price. If the RBI wants to make it more expensive for the banks to borrow money, it increases


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the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the

repo rate.

The reverse of the repo transaction is calledreverserepowhich is lending of funds against

buying of securities with an agreement to resell the said securities on a mutually agreed future

date at an agreed price which includes interest for the funds lent.

The RBI uses this tool when it feels there is too much money floating in the banking system.

With the increase in reverse repo rate, RBI gives bank a lucrative rate for depositing money.

Thus,banks prefer to deposit money with RBI rather than lending it. It results in reduction of

money circulation in an economy and thus purchasing power.

LAF enables liquidity management on a day to day basis. This arrangement allows banks to

respond to liquidity pressures and is used by governments to assure basic stability in the financial

markets.

Marginal Standing Facility Rate: Banks will be able to borrow up to 1% of their respective

Net Demand and Time Liabilities. The rate of interest on the amount accessed from this facility

is 100 basis points (i.e. 1%) above the repo rate.

This scheme will reduce volatility in the overnight rates and improve monetary transmission.

This measure has been introduced by RBI to regulate short-term asset liability mismatches more

effectively.


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The impact of monetary policy

Economic activity generally follows a cycle increased activity in terms of output and

employment, followed by decreased activity. Countercyclical policies act to promote or support

growth and employment when the activity is at a low ebb and vice versa. The objective is to

achieve balanced and sustained economic activity over time, preventing adverse features like

high inflation, and fiscal and current account deficits. Therefore, policies also follow a cycle, a

tightening phase followed by an easing phase.

In India, the current operating procedures of monetary policy using the three major instruments

of policy, namely, repo rate, reverse repo rate and the cash reserve ratio, were initiated since

early 2001.

It will be interesting to see how the policy cycles have behaved since then. If we consider

increases in one or more rates of the above three major instruments as a tightening phase and

decreases in rates as an easing phase, since April 2001, the periods fall into four phases, two

phases each of easing and tightening.

EASING AND TIGHTENING PHASES

The first periodPhase I runs from April 2001 to August 2004, an easing phase; Phase II from

September 2004 to September 2008, a tightening phase; Phase III from October 2008 to January

2010, an easing phase; and the Phase IV from February 2010 till date which is a tightening

phase. As monetary policy aims at maintaining price stability and supporting growth, an easing

phase represents larger emphasis on growth and a tightening phase represents greater focus on

containing inflation. The intensity of easing or tightening can be gauged by the extent of the

increase in rates in a given cycle, as also from the duration of the cycle (see Graph). In phase I,

CRR was reduced from 8 per cent to 4.5 per cent, the repo rate from 8.75 per cent to 6.0 per cent,

and the reverse repo rate from 6.75 per cent to 4.50 per cent. For the sake of brevity, if we

combine the rate changes into a single figure, it is revealed that the combined decrease in rates

was 850 basis points in Phase I.


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On a similar basis, Phase II witnessed a combined increase of 900 basis points, matching the first

phase. Phase III coinciding with the crisis resolution phase, saw a combined decrease of as much

as 1100 basis points, all rates touching their historical lows. In phase IV, since February 2010, a

continuing tightening phase, the combined increase has so far been 450 basis points.

What about the duration of the cycles? Phase I lasted for 41 months, II for 49 months. The easing

phase III lasted only for 17 months, but that is because the recovery from the impact of the

global crisis was faster, and inflationary pressures surfaced quickly.

Based on the earlier evidence, it seems that the current phase of tightening may last for at least

another year. But it may go on for longer, depending upon the vulnerability of Indian economy to

domestic and global destabilising factors.

The current phase has the added risks of high inflation, widening current account deficit and

fiscal deficit. Any extraordinarily accommodative monetary policy, supportive of the growth

momentum may land up in very high inflation with unsustainable external sector balances.

OUTPUT, INFLATION RESPONSES

A surprising result is that no particular relationship could be established between the policy rates,

money supply and inflation based on consumer price index (CPI). The average monthly year-on-year CPI inflation seemed to have accelerated in a secular fashion from 3.9 per cent in phase I to

5.9 per cent in phase II and to 11 per cent and 12 per cent in subsequent phases (see Table).

Likewise, M3 growth showed no particular relationship.

The output response as also the response of inflation based on wholesale price index (WPI),

seemed to have performed as expected to easing and tightening cycles, but with a lag. The easing

first phase caused the quarterly average year-on-year growth rate to pick up significantly from

4.9 per cent to 9.0 per cent in the second phase; the tightening during the second phase had

caused the average rate of growth to decline to 7.6 per cent in the third phase; and the easing in

third phase has contributed to the higher growth rate in phase IV at about 9.0 per cent till date.

Similarly, the easing phase I pushed the WPI inflation rate to 5.8 per cent in phase II from 4.4

per cent, but the tightening phase in phase II was followed by low WPI inflation of 3.8 per cent.


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The easing phase of III has now been followed by an average WPI inflation of 9.7 per cent, thus

far in the still running in phase IV.

POLICY IMPLICATION

Though these inferences are very crude and subject to more rigorous tests, one can broadly

conclude that while monetary easing and tightening seem to have impacted growth and WPI

inflation with a lag, any containment of CPI inflation, which is more amenable to supply and

external shocks, would require enduring supply responses of wage goods and improvements in

distribution.

The present study was an attempt to analyze systematically the techniques of monetary control

measures with its relevance and changing importance and to find out their effectiveness in theIndian context especially to achieve the thriving objectives of price stability and economic

growth.There is definite and remarkable economic impact of monetary policy on Indian

economy in the post-reform period. The importance of monetary policy has been increasing year

after year. Its role is very relevant in attaining monetary objectives, especially in managing price

stability and achieving economic growth. Along that, the use and importance of monetary

weapons like Bank rate, CRR, SLR, Repo rate and Reverse Rate have increased over the years.

Repo and Reverse Repo rates are the most frequently used monetary techniques in recent years.

The rates are varied mainly for curtailing inflation and absorb the excess liquidity and hence to

maintain price stability in the economy. Thus, this short-time objective of price stability is more

successful on Indian economy rather than other long-term objectives of development.Monetary

policy rules can be active or passive. The passive rule is to keep the money supply constant,

which is reminiscent of Milton Friedmans money growth rule. The second, called a price

stabilization rule, is to change the money supply in response to changes in aggregate supply or

demand to keep the price level constant. The idea of an active rule is to keep the price level and

hence inflation in check. In India, this rule dominates our monetary policy. A stable growth is

healthy growth.


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Monetary Policy and its implication on Indian Economy

The recent time has seen a dynamic change in Indias macroeconomic health. The inflationary

tendency either caused by supply side elements or the food commodities has impacted on Indias

rising as economic superpower. The economic survey of 2010-11 attributes a 9% growth ofIndian economy. In the era of globalisation no economy can be isolated or completely shielded

from the global trends of the market. But the severity of effect can be controlled through the

tools of monetary policy. The reserve bank of India utilises the tools i.e. both quantitative and

qualitative to influence interest rates, inflation and credit availability through changes in the

supply of money available in the economy.

In the monetary policy released on May 3rd 2011 RBI has increased the Repo rate to 7.25%, a 2

percentage point increase from the earlier 5.25% of the last year. It has also increased the reverse

repo rate to 6.25% and more importantly ceased its independent nature as now reverse repo is

linked to repo rate i.e. it shall be 100 points below it.

The RBI's objective as per the statement issued on May 3rd 2011 notes:

Over the long run, high inflation is inimical to sustained growth as it harms investment by

creating uncertainty. Current elevated rates of inflation pose significant risks to future growth.

Bringing them down, therefore, even at the cost of some growth in the short-run, should take

precedence.

An increase in international commodities price backed by strong demand has indeed spread its

effect on the national economy. The investment-led-growth has resulted into increase in

inflationary tendencies which certainly can put a speed breaker in the growth of Indian economy.


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As a result the increase in repo rate, the cost at which RBI lends short-term capital to banks,

might lead the banks to increase their lending rate for their customers. This in turn might impact

on the commercial interest rates banks propose for their customers. Thus lead to reduction in

inflation by absorbing more liquidity from the market. All this while we assume the demand

remains strong as it is now.

The present action has its impact in the long run of overall economy. Thus shifting the target of

various government funded programs, including the 11th Five year plan. Analyzing present

situation and learning from the past trends of our economy. The new scenario certainly would

put new challenges in our growth.

Presently, the Indian economy is overflowing with liquidity as a result of massive inflow of

foreign capital. The ability of banks to lend has encouraged them to seek out potential borrowers

and increase product in the retail loan category. In the event, even at a time when GDP growth

had been accelerating, credit had grown at an even faster rate.

The schedule commercial bank credit-to-GDP ratio in the country, which rose from 20.4 per cent

in 1990-91 ( reforms in India ) to 25.3.4 per cent in 2001-02, had risen to 52.1 per cent by 2009-

10.* (RBI Handbook of Indian Economy 2009-10).

Accompanying this rise in credit provision was an increase in loans to individuals and

professionals (Personal Loans and Professional Services), whose share rose from 9.4 per cent to

16.8 per cent between end-March 1990 and end-March 2002, and then shot up to 27 per cent by

end-March 2005. This is the direction in which credit had moved, accounting for a substantial

part of excess credit growth.


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This is where the effects of the rise in interest rates over the last year are bound to be felt. Those

taking on these loans would have in recent months been faced with significant increases in the

equated monthly installments they pay. This would not only discourage further borrowing and

new borrowers, but can lead to defaults. It may also involve lending without adequate scrutiny of

income documents. The result would be an increase in the proportion of risky borrowers in a

situation of rising credit provision. As most loans are addressed to housing sector the danger of

future defaulter looms over real estate sector.

Defaults and foreclosures could increase. Such defaults are likely to significantly higher in a

period of rising interest rates, with adverse consequences for bank profitability and even

viability. A tight monetary regime would hamper the money movement thus affecting the rising

corporate sector and stock markets.

This is only one side of the story as it sticks to the monetary implication from the consumer side

only. The fiscal side too has a large role to play when the task of controlling inflation has to be

considered. The governmental action of raising the administered price of food distribution

through public distribution system, frequent hiking the price of petroleum products, high

dependency on fertilizers thus increasing the cost of agriculture which are all subsidized in

nature in turn aggravates inflationary tendencies.

The money poured in the Flagship programs and the new food security programs would

definitely lead to demand- supply imbalances. Ultimately leading to a large public debt and

creating huge fiscal gap. These are some of the speed breakers which might slow down the pace

of growth in short-run.

Apart from internal situations the global scenario has its challenges to throw at Indian economy.

The recent crisis in middle-east and North African countries has been linked to un-precedent hike

in petroleum prices. The burden of which has been felt by frequent increase in petroleum prices.

As 70% demand of crude oil is met by imports. International oil prices fluctuations are reflected


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in our economy. This has the potential to affect the largest section of consumers as every

commodity available feels the heat and hence leads to further increase in price.

The rising international trade has exposed us to international markets, if the present facilities

given to enhance the industrial setup across India bear a cost cut scenario in the name of bridging

the fiscal gap. International challenges might directly affect our industrial output which in turn

has the ability to change equation of our internal market.

As comparison to China, our industries are yet to pick up the pace to deliver global demands and

meet international expectation. Chinese economy, being a controlled regime, has extended

facilities to meet the global manufacturing demand. Indian industries are now changing their

mode from supplement to complement the global manufacturing demand. Hence a large

investment is need of the hour. India is 2nd most favored destination for investment today. Thus

a tight monetary market can play with the aspiration of Indian industries.

Moreover as our economy is still agriculture based which serves income to largest section of

population. Any impact on the agro-economy might result in more distraught in overall

economy. The monsoon and crop production are the only beacon of hope to come out of vicious

cycle. A timely monsoon would help in good crop yield which in turn would yield to more

income at the bottom end. But a bad monsoon would lead to more dependency on electric power

(Mostly diesel generators) to pump water. This would increase the cost of agriculture production

and might turn the commercial farming to a subsistence farming activity.

The new monetary policy declares that RBI will have only one single policy rate, the repo rate,

to indicate the rate changes in the banking system. Further, this would enhance the transmission

of monetary policy and reduce volatility in overnight call money rates.


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The reverse repo rate (the rate at which banks park their funds with the central bank) will

continue to be operative, but it will be pegged at a fixed 100 basis points below the repo rate.

Hence, the reverse repo rate will no longer be an independent variable.

RBI has instituted a new Marginal Standing Facility (MSF) under which banks can borrow

overnight from the MSF up to one per cent of their respective net demand and time liabilities

(NDTL). RBI will receive requests for a minimum amount of Rs 10 million and in multiples of

Rest 10 million thereafter. The central bank has the right to accept or reject partially or fully, the

request for funds under this facility.

Rising commodity prices, increased fuel subsidy, subsequent risk of overshoot in government

borrowing and pressure on trade gap are factors which would make the central bank's task more

difficult.

The present policy directs to control inflation to a more controllable margin. Hence a little slow

down is still acceptable rather than a long run gap by the inflation. The action taken by RBI is

unique and it is only after the next quarter a visible result can be expected. Till then the

uncertainty in the market shall remain as a threat.

Indias record GDP growth throughout the last decade has lifted millions out of poverty and

made the country a favored destination for foreign direct investment. However, the sharp

downturn in Europe and the United States, coupled with significant domestic challenges, has

slowed this trend and stands to disrupt future growth.

In an interview with NBR, India-based economist Pravakar Sahoo (Institute of Economic

Growth) discussed the outlook of Indias economy and the role that fo reign investment might


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play in stimulating growth. Dr. Sahoo argues that the country will not realize the full potential of

outside investment unless the government confronts political opposition to key policies, such as

allowing FDI for multi-brand retailers like Walmart and Target, and undertakes crucial reforms

to sustain investor confidence.

Growth in the Indian economy has slowed and inflation has risen in the last several months.

What have been the primary triggers for this slowdown?

The Indian economy recovered well after the global financial crisis due to a fiscal stimulus

package and also many social programs like the Mahatma Gandhi National Rural Employment

Guarantee Act. These activities created employment and demand that resulted in 9% GDP

growth in 2010. However, GDP expansion for 2011 is now expected to be 7.0%, not the

forecasted 8.5%.

Several major factors are responsible for this slowdown, including the continuous rise of

inflation, a tight monetary policy, a series of corruption scandals, policy paralysis on crucial

reforms, and a lack of infrastructure development. Tight monetary policy for the thirteenth

consecutive quarter has increased the cost of capital and affected credit flows to the commercial

sector, slowing down overall investment activity. However, monetary policy has not been

effective in containing Indias inflation, as this inflation is primarily a supply-side phenomenon

due to a deficiency in infrastructure and bottlenecks in supply chains. Furthermore, a lack of

investor confidence and positive business sentiment has led to declining FDI inflows over the

last three quarters, adding pressure on new and ongoing investment.

In addition, capital outflow, triggered by lackluster investor confidence and the European debt

crisis, has resulted in a huge loss in listed shares market valuation on the Bombay Stock

Exchange. All of this points to slower growth in the near future.

The Indian government canceled plans to allow FDI in the countrys retail sector. What caused

this recoil?


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When the cabinet decided to allow 51% FDI in multi-brand retailing and 100% FDI in single-

brand retailing, though subject to conditionalities, this was extremely good news and a long-

awaited boon to large international retailers who had been eagerly waiting to tap into the

estimated $600 billion Indian retail market and the purchasing power of Indias fast-rising

middle class. This policy decision could have been one of Indias biggest in terms of having a

positive impact on producers, consumers, and the overall conduct of business in India and could

have attracted tremendous amounts of FDI.

Unfortunately, this politically sensitive decision incited furor from right-wing political parties

such as the Bharatiya Janata Party, left-wing Communist parties, and some alliance partners for a

number of reasons. The timing of the decisionmade during a parliamentary sessionwas not

appropriate, as the federal government has been challenged recently by opposition parties on

issues like corruption, never-ending price increases, black money, policy paralysis on crucial

reforms, and a mass movement led by anti-corruption crusader Anna Hazare.

What effect could the retail FDI decision have on the domestic economy and for foreign

companies doing business in India?

Should it have gone into effect, the multi-brand retailing decision would have impacted different

stakeholders widely. The scale economies of organized retailing would likely have offered

consumers a wider variety of products at lower prices, with safeguards like quality control and

checking for counterfeit products, including infringed American goods. Organized retailers

would also have to buy products directly from Indian farmers and producers, paving the way for

better price realization. The provision of 50% FDI from the United States and elsewhere in back-

end infrastructure for storage, logistics, and better extension services would substantially reduce

wastage in Indias farm produce, which is one of the highest in the world. The provision of 30%

sourcing from Indian SMEs (small and medium enterprises) would have helped expand capacity,

improve quality, and get exposure to international supply chains, making them internally

competitive over time.


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Countering these positive aspects, however, the initial impact of multi-brand retailers entering

Indias market is expected to have a negative impact on the over 12 million unorganized shops

and countless kirana (mom-and-pop) stores, as they lack the financial muscle to challenge major

retailers in terms of variety, quality, packaging, and other offers.

If citizens and opposition parties become more receptive, might New Delhi try to further open

the retail sector in the near future? Would any future deal need to be altered to incorporate the

oppositions concerns? If so, how?

The government should have discussed the retail FDI matter with opposition parties and its

alliance partners before getting approval from the cabinet. It eventually succumbed to outside

pressure and suspended FDI in multi-brand retailing, and is unlikely to reopen the issue until

after the 2012 state elections in Uttar Pradesh, Punjab, Uttarakhand, Manipur, and Goa. The

Singh government would like to weigh its political position in these states after the elections

before it makes tough decisions on issues such as FDI in multi-brand retailing. The flip-flop in

retail FDI has created more uncertainty among investors and created doubts about further big-

ticket market reforms in the near future.

To move forward, it is time that the Singh government talks to opposition and alliance partners

about the benefits of multi-brand retail FDI. However, the political climate will be much clearer

after parties position themselves leading to the state elections early this year. In addition, the

government also needs to educate stakeholders like producers and consumers about the

beneficial effects of FDI in multi-brand retailing, as not enough has been done on this front.

Is there anything else New Delhi can do to assuage outside fears of a slowdown in India?

The Indian economys biggest strength is that India is still the second-fastest growing nation next

to China, with an annual growth rate of over 7%, and its growth is mostly led by domestic

demand. Therefore, the government needs to do everything possible to sustain investors


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confidence and a positive market sentiment. To indicate that India is serious about market

reform, the government should put on the fast track some of the other big-ticket reforms such as

retail FDI, banking, pension, insurance, civil aviation, labor reforms, land acquisition, and clarity

over environmental issues. Movement toward reform and good governance are necessary to

bring back investor confidence in the Indian economy.

The industrial sector has slowed down due to increasing costs of production, increases in policy

rates over the last few quarters, numerous scams and damage to corporate credibility, renewed

debate over land acquisition, and environmental clearances. Unfortunately, governance and

corruption issues are delaying reforms, leading to a loss of faith in the Indian economy.

What kind of impact has Indias slower economic growth had on trade and economic relations

with the United States and other partners like China and Europe? If this trend continues over the

next year, what can outside observers expect?

Indias economic slowdown may certainly affect the countrys external sectors, including the

countrys bilateral trade with the United States. Chinas cost of domestic production is rising,

and many investors, including some from the United States, are looking to India as an alternative

destination. As many foreign investors look to tap into Indias domestic market, capital inflows

could decrease. In fact, if the downturn continues, there may be more outflows of capital from

India than inflows to India.

India is a major buyer of American products, particularly high-value and technology-intensive

products in sectors such as defense, and a slowdown in the Indian economy would likely affect

trade between the two countries.


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What are the political implications of Indias economic slowdown?

If the slowdown continues and reduces resource mobilization, it would jeopardize the effective

implementation of the Indian governments grand social programs such as the right to education

and the new food security bill. Regarding the latter, in December 2011, Indias cabinet cleared a

bill to provide food at highly subsidized rates to 60% of the population, amounting to roughly $6

billion per year. These mandatory programs require a tremendous amount of resources at a

growing rate and are only possible if economic growth continues. If not, the governments fiscal

deficit will breach its limits and, along with increasing the current account deficit, will create

undesirable effects for the Indian economy. Indias twin deficits will use up both domestic

savings and foreign savings to manage the economy and will lead to high inflation, the crowding

out of private investment, high interest rates, and difficulties in managing monetary policy. India

has experience with deficits leading to a balance-of-payment crisis, as occurred in 1991.

Growth is necessary for the government to meet the socioeconomic infrastructure requirements

for a majority of the population. Lagging investor confidence and an economic slowdown in

manufacturing and industry would disappoint the aspirations of millions of young people

searching for jobs. With a median age of 25 years, India has a young population compared to

other Asian countries like Japan and China, which need to deal with an aging population. Now

India must sustain its growth and create jobs to reap the rewards of its population dividend.

What else can the Indian government do to attract foreign investors?

The post-liberalization period has been remarkable for FDI in India. It has created a conducive

environment for foreign investment by abolishing industrial licensing, establishing institutions,

lifting FDI equity ceilings, shifting more sectors to the automatic route, providing incentives, andliberalizing foreign exchange regulations. Consequently, FDI inflows, negligible before 1991,

have increased substantially.

FDI in India is still concentrated in a few sectors and states. Factors that hinder FDI inflows

include infrastructure bottlenecks, rigid and complicated labor laws, lack of coordination


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between the states and the central government, lack of reforms at the state level, FDI equity caps

in many potential sectors, and delays in getting multiple clearances and approvals.

Future reforms and policies need to address these issues and set up appropriate institutions. Some

necessary reforms include: creating a better environment for infrastructure development with anappropriate institutional framework such as a dispute-resolution mechanism, independent

regulatory authority, and special investment law; establishing a uniform labor code after an

independent review and proper consultation with stakeholders; ensuring proper design and

planning of special economic zones (SEZ), including local-level solutions for land acquisition

and sector-specific policies with incentives to attract FDI into SEZs; revisiting outdated laws,

controls, regulatory systems, and government monopolies affecting the investment environment;

and last, encouraging nongovernmental facilitation services for foreign investors.

Overall, India needs to address its lack of adequate infrastructure, rigid labor laws, and

bureaucratic delays and make state-level reforms to realize its FDI potential.

What are the primary issues for the Indian economy at this moment? What are the major hurdles

to making Indias growth more inclusive and sustainable?

The most pressing issue for the Indian economy now is to improve competitiveness across all

sectors. If India desires to be an economic power, it needs to reduce trade and transaction costs,

improve governance, and carry out institutional reforms for effective law enforcement.

A serious problem that might halt the Indian economys growth is the countrys infrastructure

bottleneck. Lack of high-quality physical and social infrastructures have led to high costs in trade

and transaction costs, thereby lowering Indias economic competitiveness. The planning

commission has estimated that the infrastructure sector requires investment of up to $1 trillion in

the 12th Five Year Plan (201217), but it may be difficult to raise such funds.

The service sector, which was the driver of growth for the last two decades, has also showed

signs of a slowdown in the last few quarters. Decreased output in the industrial sector, along with

low demand for Indias services in the United States and Europe, has resulted in a slowdown for


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services exports as well. Given the current situation, particularly the European debt crisis and the

overall slowdown in developed countries, a moderation in exports in general, and trade in

services in particular, is expected.

India also faces internal problems, such as widespread poverty, corruption, and poor governance.Market reforms over the last two decades have created opportunities for the private sector to

grow, resulting in a high growth rate, but they have also produced high inequality in India.

Growing inequality and a high poverty rate (more than 30% of the population) are the biggest

challenges to sustained economic growth, and if not addressed properly, will create disharmony.

A primary step that the Indian government must take to reduce inequality and poverty is to

improve productivity growth in agriculture. More than 56% of the total labor force depends on

agriculture, although this sector contributes only 16% to Indias total GDP. The government

should institute policies that provide education and vocational training in order to move people

out of agriculture and make use of opportunities in the market economy.

What is the impact of the sudden decrease in the value of the rupee on both trade and the Indian

economy?

The fall of the rupee by more than 15% since August 2011 is a blow to Indias economy. Costlier

imports of petroleum products, steel, and rubber will add pressure to the price of production in

manufacturing and inflation in general, which has been around 9% for the last couple of years. In

fact, Indias top exports are in the same industry as Indias top imports, showing high and

increasing intra-industry trade. In some industries, like automobiles, electronics, and computer

hardware, India primarily imports intermediate inputs, and an increase in price for these inputs

will be passed onto consumers, which contributes further to price increases. More importantly,rising production costs would reduce profit margins and overall investment activities. The

favorable impact on exports would be modest and confined to a few sectors, especially with

consumer demand slowing in the United States and Europe.


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The present scenario also does not augur well for Indias external sector and fiscal deficits.

Given the sticky components of imports such as petroleum and expected lower favorable impact

on exports, the trade deficit is likely to go up. In addition, a decline in capital inflows would

contribute to the current account deficit. The prospect of a higher current account deficit and

trade deficit will make investors in general, and foreign investors in particular, more skeptical

about the Indian economy.

What are some indicators or benchmarks to look at in order to assess if Indias economy is

experiencing a turnaround?

There is no one indicator to detect a turnaround. Indias economy faces multiple challenges,

including a slowdown across many sectors and high inflation. However, the first thing one

should look for is a turnaround in investment trends, particularly in private investment, which

has slowed substantially due to a lack of a conducive business environment and policy paralysis.

An increase in private investment and inflows of foreign capital, both FDI and institutional

investment, would reflect a revival of the Indian economy.

The reduced production of capital goods and intermediate goods in the manufacturing sectors

over the last few quarters reflects a decrease in overall economic activity. Improvement in

manufacturing and an increase in net sales and corporate profits would demonstrate a reversal of

trends in these sectors and would be good indicators of a broader economic turnaround. Finally,

strong performance in agriculture and the service sector, along with moderate inflation, would

likely eliminate existing structural imbalances in the Indian economy.

For all this to happen, however, India needs to fast-track major policy decisions on issues

ranging from land acquisition and fiscal consolidation to banking and insurance reform, alongwith implementing policies to improve the countrys overall governance.


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Development of Financial Markets and Interest Rate

Inter-linkages across Markets

An effective implementation of monetary policy needs an assessment of how the monetary

policy changes propagate through the financial markets and the broader economy. In general,

monetary policy gets transmitted to final objectives of inflation and growth through two stages.

In the first stage, policy changes transmit through the financial system by altering financial

prices and quantities. In the second stage, financial prices and quantities influence the real

economy by altering aggregate spending decisions of households and firms, and hence the

aggregate demand and inflation. Nonetheless, whether monetary policy actions influence the

spectrum of market interest rates would inter alia depend upon the level of development of

various segments of financial markets. Cross-country studies suggest that as domestic financial

markets grow, transmission of monetary policy through financial channels becomes better.


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Therefore, before going for empirical investigation onto the impact of monetary policy on

various segments of financial markets, it is important to briefly review the policy measures

which have been taken during the post-reform period to deepen interest rate inter-linkages.

Various measures were taken to facilitate the process of price discovery in different segments of

financial markets which inter alia included deregulation of interest rates;auction-based market

borrowing programme of the government; development of short-term money markets through

introduction of money market instruments; discontinuation of automatic monetisation by phasing

out of ad hoc Treasury Bills; replacing cash credit with term loans, and reduction in statutory

reserve requirements. These reforms facilitated a shift in the operating framework for monetary

management from direct instruments to interest rate based indirect instruments. Even though the

financial reforms began in the early 1990s, the impact was evident from the late 1990s.

Money Market: The development in money market assumes prime importance as it is a key link

in the transmission mechanism of monetary policy to financial markets and finally, to the real

economy. The call money market was developed into primarily an inter-bank market, while

encouraging other market participants to migrate towards collateralised segments of the market,

thereby increasing overall market integrity.

In order to facilitate the phasing out of corporates and the non-banks from the call money

market, new instruments, e.g., market repos and collateralized borrowing and lending obligations

(CBLO) were created to provide them avenues for managing their short-term liquidity. Non-bank

entities completely exited the call money market in August 2005. Maturities of other existing

instruments such as CP and CDs were also gradually shortened.

Debt Market: Another segment of financial markets which plays a crucial role in the monetary

policy transmission mechanism is the debt market, in particular, the government securities

market as it is the predominant segment of the overall debt market in India. Banks still statutorily

hold 24 per cent of their net demand and time liabilities (NDTL) in government securities.

One of the key policy developments that enabled a more independent monetary policy

environment as well as the development of government securities market was the discontinuation

of automatic monetisation of the government's fiscal deficit since April 1997. This reinforced the

auction based system in the government securities market which was introduced in 1992. The


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Primary Dealer (PD) system was also revamped to ensure a more dynamic and active

participation of PDs in view of the provisions of the Fiscal Responsibility and Budget

Management (FRBM) Act 2003 whereby the Reserve Bank was prohibited from participating in

the primary market effective April 2006. As a result, a shift towards market-based financing of

the government borrowings and an active secondary market for government securities expanded

the eligible set of collaterals which enabled the RBI to more effectively conduct monetary policy

through indirect instruments. While the government securities market in India is considered to be

well developed now, the corporate debt market remains comparatively less developed with

implications for monetary transmission.

Credit Market: Prior to the 1990s, credit market in India was tightly regulated through credit

controls, directed lending and administered interest rates. However, with financial reforms

pursued since the early 1990s, not only the banks were provided flexibility to price their products

based on their risk assessment, but also restrictions on lending for project finance activity and for

personal loans were gradually withdrawn. Furthermore, international best practices were

progressively adopted in respect of regulatory norms on capital adequacy, income recognition,

asset classification and provisioning. The problem arising out of segmentation of the credit

market was addressed with banks providing long-term loans, apart from the traditional short-

term funds for working capital. The linkage between the credit market and the equity market has

also grown on account of participation by banks in the equity market for raising capital.

Foreign Exchange Market: There was a phased transition from a pegged exchange rate regime to

an increasingly market determined exchange rate regime in 1993 and the subsequent adoption of

current account convertibility in 1994 and significant liberalisation of capital account

transactions. The increasing freedom given to corporates and banks to borrow abroad and use

derivative products enhanced the linkage of Indian foreign exchange market with the global

financial system.

Asset Market: Stock prices are among the most closely watched asset prices in the economy.

Equity market in India has witnessed a series of reforms which were aimed at boosting

competitive conditions through improved price discovery mechanism; putting in place an


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appropriate regulatory framework; reducing the transaction costs; and reducing information

asymmetry, thereby boosting the investor confidence.

Integration across financial markets

As price discovery improves and the range of instruments expands, economic agents tend to hold

more interest rate sensitive instruments in their balance sheets. Similarly, increasing

monetization and progress towards financial inclusion have also expanded the formal financial

system in the economy which ought to enhance the scope of monetary transmission.

Monetary Policy Effect on Output

The impulse response functions imply that increase in policy interest rate is associated with a fall

in real GDP growth rate. The maximum decline in GDP growth occurs with a lag of two quarter

with the overall impact continuing through 6-8 quarters ahead. The impulse response is broadly

similar with the alternative models with variants of output, inflation, money and credit.

(ii) Monetary Policy Impact on Inflation

The impulse response functions imply that increase in policy interest rate has a negative impact

on inflation rate across the alternative measures of inflation. The maximum decline in inflation

was observed with a lag of three quarters with the overall impact continuing through 8-10

quarters.

Causality Analysis

In order to assess causality between financial variables including the policy rate and

macroeconomic variables of growth and inflation, block exogeneity tests were conducted.

First, the model was divided into two blocks. One block included the macro-variables (output

and inflation), while the other block covered the financial variables such as the policy interest


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rate, monetary aggregates and credit. Generally, bidirectional causality was found between the

two sets of blocks (Annex 3). This suggests that while monetary policy responds to changes in

output and inflation, they in turn influence monetary variables.

Second, with a view to examining how changes in policy rate affect other set of variables,

alternative block exogeneity test was performed with the first block as policy rate (call money

rate) and the second block consisting of other variables, i.e., output, inflation and a quantity

variable such as money or credit. In this case, empirical results suggest a unidirectional causality

running from changes in policy rate to other set of variables. (Annex 4) The results were similar

when money and credit were used in real terms except for broad money (M3).

Indian Economy: Outlook and Prospects: FY12 and FY13

In January 2012, CARE Ratings released its projections of various economic variables for 2012

and 2013. The Report projects that Indias GDP growth in FY12 will be 7%, which is likely to

rise to around 7.5% in FY13 under certain assumptions made relating to the global economy and

domestic policy responses. Inflation on the other hand is to moderate to 5% in FY13 based on a

good harvest and stable global commodity prices.

The projection for the fiscal deficit for FY12 has been placed at 5.5% which is expected to range

between 5-5.5% in FY13 mainly due to pressure on the expenditure side. The RBI is expected to

lower interest rates in the course of the year, with the repo rate coming down by 100-150 bps.

The outlook further expects the rupee to remain volatile as euro conditions will remain in flux

while the domestic current account deficit will be under pressure at 3% of GDP which will still

be an improvement over the 3.5% deficit expected in FY12.

Speaking on this outlook, Mr. D R Dogra, MD & CEO, CARE Ratingssaid, We do expectthe economy to recover gradually in FY13 which is encouraging. However, the challenges

remain on the policy fronts, and I think that the fiscal deficit target for FY13 will hold the clue to

how things pan out during the year. Given that investment has been slack in FY12, we do hope

that it picks up so that the growth objective is achieved. We would be expecting the government


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to come up with some big plans in the infrastructure space. A robust growth and investment

environment is necessary for maintaining corporate ratings.

Indian Economy Data and Statistics for 2012 and 2013

The economic conditions in the country in the current fiscal have been challenging with inflation

being the major factor driving economic policy. This has had a major impact on other economic

variables with official projections being modified downwards along the year. Policy formulation

has become even more difficult with the volatility witnessed in the forex market, where the rupee

has tended to move downwards. The prospects for FY12 may be drawn based on the present

combat against inflation, slowing down of investment, pressure on budget deficit, wideningcurrent account balance, depreciating rupee and uncertain capital markets. Expectations for

FY13 are based on certain perceptions on the state of the global economy as well as the expected

policy of domestic authorities.

About Indian Economy Prospects for FY12

Growth expectations

GDP growth is to be driven mainly by the services sector which excludes any stimulus from the

part of the government. Overall growth is expected to be in the range of 7% in FY12. This is
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creditable and would still be one of the highest in the world with only China, Argentina, and

Turkey being ahead.

Farm growth at around 3% will be major comfort for GDP growth and will also mean a second

successive harvest after the drought of FY10. Production is to be boosted mainly by cereals such

as rice and wheat and cash crops such as cotton, jute and sugarcane. This has provided both

demand for non-farm goods as well as supplies for the manufactured food products which has in

turn helped growth of industry.

Industrial production (including construction), which was to grow in the region of 8-9% for the

year would be fairly subdued even from the 7.1% projection made by the PMEAC in July. With

fairly volatile numbers so far this year and negative growth in October, overall projections havebeen lowered to the range of 5%, which will still mean a substantial recovery in the last 4 months

of the year, which on a high base, will be an achievement. Major risks in this area are in the

mining and capital goods sector. For the former, policy action is required while for the latter, a

revival in investment is called for. Absence of affirmative action in areas such as reforms in

mining, land, insurance, pensions, banking, taxation etc. along with high interest rates have come

in the way of investment growth. While it is expected that we have reached the end of the

interest rate cycle, the progress on reforms is expected to be tardy till the first quarter of FY13.

The service sector, with a weight of around 60% in GDP will be the chief driver with growth of

around 9% during the year. Growth is expected to be broad based with only the government

sector showing a slowdown.

Fiscal outcome

The fiscal deficit for FY12 will not meet the Budgets target of 4.6% of GDP and would be

higher on account of revenue slippages and excess expenditure. Based on the revenue loss fromindirect taxes announced in mid -2011 as well as the higher government borrowings of over Rs

90,000 cr announced by the RBI for the year, the ratio is to slip towards the 5.5% mark,

assuming that there are no further shocks.


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The question marks remain over the progress of the disinvestment programme of Rs 40,000 cr

(only Rs 1,444 cr has been mobilized until now) and subsidy bill which has already overshot the

budgeted amount of around Rs 145,000 cr. While there are mechanisms being put in place for

enabling the disinvestment programme, it is uncertain as to what could be the level of success.

Hence, the deficit level of 5.5% of GDP is a more conservative estimate, which is subject to an

increase if these assumptions are violated. Also it should be noted that statistically the deficit

ratio is being supported by a highe r denominator as the overall growth of GDP at current market

prices would be between 2-3% higher than was envisaged at the time of presentation of Budget

2011-12.

Inflation view

Inflation as given by the WPI will move towards the 7% mark earlier than expected and could

touch 6-6.5% by March end on a point to point basis guided by negative food inflation. The

present trend of negative food inflation is being assisted by the base year effect which will wane

by the end of the year. However, pressure will continue to be exerted by core and fuel inflation

as the international crude prices will remain at the existing level which together with a weak

rupee will exert pressure on prices. The government at best will not increase petro product prices

this financial year and take on the additional cost aa part of the subsidy bill.

Monetary developments

Monetary indicators look to be weaker this year with growth in credit being 16% and deposits

18%. Growth in deposits is well ahead of that in credit and will continue to be so for the rest of

the year. Surplus funds are being deployed in government paper thus enabling the governments

borrowing programme.

Given the uncertainty over inflation, the RBI is unlikely to touch rates till March end even if the

inflation number declines to 6-7% before that as core inflation is a concern and the central bankhas to be certain that inflation will remain at lower levels before invoking an about turn in policy.

Policy action

While a CRR cut is possible to induce liquidity to ensure that the borrowing programme of the

government goes through, the RBI may prefer to use OMOs as a CRR cut is viewed as being


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rather permanent, as a part of policy stance and reducing the same could send contradictory

messages to the markets. The RBI has been following an anti-inflationary policy stance since

early 2010.

Liquidity will continue to be under pressure this year since, with credit growth also picking up to

support commerce there will be additional demand from both the government and industry. This

will keep GSec yields steady and that on 10 -years will range between 8.2-8.5%. More

borrowings will increase supply of paper that will depress prices, and consequently move yields

upwards.

External sector outlook

The external account will be under pressure till March 2012. The trade deficit has been wideningwith growth in exports slowing down while imports continue to increase at a steady pace. This

year so far, remittances and software flows have provided support to the current account. With

these flows continuing to increase, albeit at a gradual pace, the current account deficit will in the

range of 3.5% of GDP this year.

Capital receipts have in the past provided support to the current account deficit. However, this

year, FII flows have been just $ 6 bn till December and concentrated in debt. This number is not

likely to improve substantially and would at best be around $ 10-12 bn by the end of the year.

FDI however is the major supporting factor here, with around $ 20 bn coming in the first 7

months of the year. The target of around $ 30 bn is likely to be achieved.

In case of ECBs, the target of over $ 35 bn is unlikely to be met, thus leading to pressure on the

overall balance of payments and reserves. Given the pressure on the balance of payments, the

rupee will continue to be under pressure in the range of Rs 50 -52/$ till March. However, any

major shock in the global economy would change this range.

Outlook for 2012

The outlook for 2012 and further till March 2013 will be based on two sets of factors.


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Global factors:

The world economy is in a state of flux with the euro rescue package still being implemented.

The recent downgrading of 9 nations has further added to the uncertainty with a possibility of

further default problems in Greece resurfacing. Assuming that there are no further failures in the

euro region and the rescue packages are to be implemented, there would be a tendency for

countries to resort to fiscal austerity which in turn will slow down these economies. Therefore,

overall growth here will be muted for a second successive year, and at around 0.5-1% compared

with 1.5% in 2011. This would also be contingent on strong recovery in Germany and France.

While ECB could lower rates in the course of the year by up to 50 bps, it is unlikely to have a

perceptible impact given the fiscal concerns in most of these nations . This said, markets will

continue to be volatile as the debt ridden nations will continuously be under stress to service their

debt which in turn will affect sentiment that will be reflected mainly in the exchange rate with

the dollar.

The USA, which will probably continue its upward movement from around 1.8-2% in 2011 to

between 2-2.5% in 2012, will not be able to propel the world economy on its own given that the

emerging markets will also be under strain especially so on account of high commodity inflation

which has invoked stringent monetary measures in these countries. Therefore, the overall global

performance, which will have a bearing on trade flows and capital movements, is likely to at best

be at present levels with marginal improvement towards the end of the year.

Domestic factors

Domestic economic developments will be largely driven by three sets of policy responses:

Monetary policy, Fiscal stance, and, Economic reforms.

However, the starting point will be the inflation direction as it has an overbearing impact on all

policies. Inflation should be under control during the year at around 5% assuming that globalcommodity prices stay stable, in particular oil. With the global economy moving at a slow rate,

this is a reasonable assumption which in turn will exert some control over imported inflation.

The other caveat is a normal monsoon as this is one factor which can tilt the scales. Further, the

Ministry of Petroleums view on administered fuel prices will also have a bearing on inflation as

these products have a direct weight of around 7.5% in the WPI and also influence prices of other


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products, especially food products through transport cost. Keeping this factor as a constant, the

following is the outlook for the Indian economy in FY13.

A. GDP growth to move upwards of the present rate of 7% towards the 7.5% mark

a. Agriculture to pose a modest 2-3% growth which will come over two very good years of farm

production. The base year effect will play a leading role in the final outcome.

b. Industrial growth will start moving up based more on consumption rather than investment

demand. The impact of high interest rates and inflation on investment first witnessed in FY12

will continue to be a downside risk to industrial growth and this will slow down the recovery

process. A larger role of the government is envisaged in the new fiscal which will provide a

stimulus to industrial growth. Overall industrial growth would be in the 7-8% region in FY13

based on three factors, the absence or delay of which will upset these projections. In fact growth

would be more in the 6-7% region in case of such slippage.

i. Base year effect provides a boost

ii. Interest rates are rolled back

iii. Government spending also increases

c. Services sector will continue to be the engine to growth with a lead of 9% which will be

supported by both the banking sector, retail space, transport and communication and more

importantly the social and community services, which means more government spending.


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B. The government will have to weigh the overall external and internal environment while

formulating the Budget. While the external environment is quite nebulous, the domestic

economy deserves a push that can be provided by the government. It is expected that the focus

will be on project expenditure this time to provide a boost to the infrastructure sector so that the

linkages are forged. The deficit will be at between 5.0-5.5% of GDP based on assumptions of

moderate inflation and growth for revenue targeting. A review of the anti-poverty programme as

well as implementation of the Food Security Bill will pressurize resources and hence lowering

the fiscal deficit level further will be a challenge. Also the disinvestment programme of the

government will have to be scaled down given the uncertain times on the bourses.

C. Monetary policy will tend to be cautiously open with the repo rate to be lowered sequentially

by 100-150 bps during the course of the year. The trigger would depend on when the core

inflation number dips over the next three months. CRR cut would be invoked only in case of

tight liquidity conditions prevail and would be in conjunction with the interest rate stance. Given

that demand for funds is typically less compelling in the first quarter of the year, it would be

considered only in case of a liquidity crunch in the second or third quarter of the year and will

not be contrary to the interest rate stance.

D. GSec yields will tend to move downwards, and the 10-year rate would move in the range of

8.0-8.5% mark depending on overall liquidity conditions as well as the fiscal deficit. Liquidity

will continue to be stable with some pressure and RBI intervention will be necessitated as larger

government borrowing along with increase in domestic credit will put pressure on the banking

system.
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E. The rupee would be impacted by both global exchange rate movements as well as forex

inflows. The dollar would tend to be stable vis--vis the euro, but given lower demand conditions

in this region, there could be a tendency for the dollar to move in the range of $ 1.25-35/euro

which will cause volatility from this end. Two factors will be at work: the nebulous euro region

climate will make the euro weaker, while the recovery in USA accompanied by the growing

current account deficit can make the dollar weaken. The current account deficit may be targeted

at 3% of GDP with exports reviving, though the slowdown in euro region will continue to

pressurize the deficit. Support through remittances and software would be required to prop up the

external balance. While FDI will continue to increase FII flows will be marginally better given a

recovery in the world economy. This will help to prop up the domestic stock markets too. The

rupee will be in the range of Rs 48-52/$ during the year.

F. Concerns will remain on external debt and its composition as the debt to reserves ratio has

exceeded 1 after a long time. Debt service especially that of short term loans will continue to be

a concern going ahead.

Therefore, while a gradual recovery is expected in the economy in FY13, it is contingent on

various other assumptions holding. More importantly, policy action would be the key. While

easing of rates and liquidity will be in accordance with broader monetary policy goals of

inflation, the governments deficit will be critical as it will have to be a growth oriented budget,

which gives incentives where it is needed through taxes, spends money on infrastructure to

provide a stimulus and also meets its own social commitment expenditures.
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Interest rate hike will hurt growth, fears FICCI

An industry chamber urged the country's central bank not to raise interest rates as any further

such hike would dampen business sentiments and hurt economic growth.

Ahead of the mid-quarter review of the monetary policy, the Federation of Indian Chambers of

Commerce and Industry (FICCI) urged the Reserve Bank of India (RBI) to fine tune monetary

policy and desist from raising interest rates.

The RBI, it is expected, may hike the key policy rates further during the mid-quarter review of

the monetary policy to curb inflation, which soared to 9.06 percent.

FICCI said increase in interest rates would affect business sentiment adversely, slow down the

pace of investments further and thereby hit economic growth.

"We have seen the central bank taking swift measures, with key policy rates being hiked nine

times since March 2010, to rein in inflationary pressures. However, food inflation has proved to

be stubbornly insensitive to any such moves," Udayan Bose, chairman of corporate finance

committee at FICCI, said in a letter to RBI Governor Duvvuri Subbarao.

"As this is largely a problem arising out of demand-supply mismatch, any move to control such

inflation through monetary moves has been futile. On the contrary, aggressive monetary

tightening is having an adverse bearing on economic and industrial growth of the country," he

said.

To curb the stubbornly high inflation, the RBI has hiked key policy rates nine times in the past

15 months. The central bank raised the repo rate by 50 basis points to 7.25 percent and said that

henceforth, the reverse-repo rate would always be pegged at 100 basis points below it.

Most analysts expect at least a 25 basis point hike in the repo this time around.


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Bose said hike in interest rates would not be effective in curbing inflationary pressure.

"Inflation is no longer confined to food articles alone and has become more generalized.

However, the inflationary pressure emanating from manufactured products has less to do with

demand side pressures and is largely the result of rising input costs," he said.

"And for addressing this, we need creation of more capacities in all segments encompassing

industrial raw materials. Unfortunately, a tight monetary policy also hits at this very objective -

limiting capacity addition at a time we need it most.

India loosens monetary policy

Indias central bank surprised the markets on Friday when it loosened its tight monetary policy to

ease a credit squeeze in the banking system and moderate a sharp economic slowdown.

The Reserve Bank of India announced a 75 basis point cut in the cash reserve ratio (CRR), the

proportion of deposits banks must keep with the central bank, to 4.75 per cent. The move

injected about Rs480bn ($9.6bn) into the countrys banking system.

Indias aggressive move, the first policy action outside a scheduled meeting since July 2010,

comes after China, Brazil and Indonesia intervened to ease liquidity, as emerging economies try

to shield themselves from the European debt crisis.

The rate cut also highlights the RBIs growing concern about the liquidity crunchs impact on the

wider economy. The overall deficit in the system persists above the comfort level of the

Reserve Bank, the central bank said in a statement. Accordingly, it has been decided to inject

permanent primary liquidity into the system by reducing the CRR so as to ensure smooth flow of

credit to productive sectors of the economy.

Growth in the last quarter of 2011 was the slowest in nearly three years , rising 6.1 per cent in the

quarter ending December 31, compared to above 8 per cent a year earlier.

The latest GDP figures have already raised a question mark over growth projections for the

fiscal 2011-12, said R V Kanoria, president of the Federation of Indian Chambers of Commerc e
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and Industry. Any further delay in bringing down the key monetary policy rates by RBI could

prove to be critical forthe countrys growth trajectory, he added.

Indian companies have been begging the central bank to cut rates, as theRBIs aggressive

monetary tightening policy in the past two years to curb inflation has choked investment and hurt

growth.

Economists said that although a CRR rate slash was expected, most were surprised by the

magnitude of the cut. We had predicted a 50 basis point cut, said Anubhuti Sahay, an

economist at Standard Chartered in Mumbai. But its a positive sign that they cut more as it

shows that the bank is flexible enough to take more aggressive actions when needed.

CONCLUSION

Should the RBI have an 'easy' or 'tight' Monetary Policy?

Reserve Bank of India (RBI) Governor Subbarao will communicate to the nation the first

Monetary Policy of fiscal 2013 on 17 April. Industry and business are extremely concerned overthe nature of the forthcoming policy announcement since it has the potential to affect income,

employment, price level and output of the economy. In India, the major goal of monetary policy

is to accomplish growth without inflation.

However, one must understand that a blend of monetary and fiscal policy comprise

macroeconomic policy. Gone are the days when even veteran German economist like Rudiger

Dornbusch held the view that fiscal policy matters only in those areas where Monetary Policy is

impotent. It is also widely acknowledged that fiscal consolidation is a must for the success of

monetary policy. However, given the macroeconomic environment in the economy, monetary

policy should be considered a potent instrument to tackle inflation and boost economic growth.

The Reserve Bank of India Act, 1934 sets out the Central Banks objectives :"...to regulate the
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40 | P a g e

issue of Bank notes and the keeping of reserves with a view to securing monetary stability in

India and generally to operate the currency and credit system of the country to its advantage."

Monetary Policy in India aims to maintain price stability, ensuring adequate flow of credit to

sustain the growth momentum and secure financial stability. In order to ensure financial stability

the RBI has to regulate/supervise the financial system and its constituents namely: money, debt

and foreign exchange segments of the financial markets in India; besides the payment and

settlement system. Its other objectives are to control inflation and provide sufficient credit to

productive sectors of the economy which would foster growth.

The RBI uses three principal tools to control the size of the money supply and thereby inflation.

The Central Bank can buy government securities or bonds in exchange for money thereby

increasing the stock of money. It can also sell bonds in exchange for money paid by the

purchasers of the bonds to reduce money stock.

In addition, to the above open market operations, the RBI can raise or lower the cash reserve

ratio (CRR) -- which is the portion of deposits that banks are required to keep with the Central

Bank. Raising the CRR decreases the excess reserves of banks and the size of the demand

deposits. Lowering the CRR increases the excess reserves of banks and size of demand deposits.

The RBI can also lower the Bank Rate to encourage banks to borrow reserves from it and raise

it to discourage them from borrowing reserves. The bank rate is also known as the discount

rate, which is the interest rate that the Central Bank charges banks to borrow short-term funds

directly from it.

Monetary policy can be easy or tight. An easy monetary policy can be implemented by the

RBIs actions to buy government bonds in the open market, decrease the discount rate or


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decrease the CRR. This is done to increase the money supply to curb deflation. On the other

hand, a tight monetary policy can be implemented by RBIs actions to sell government bonds

in the open market, increase the discount rate or increase the CRR. This is done to decrease the

money supply to curb inflation. A fall in money supply can cause the interest rate to rise and

investment spending to decreasethereby reducing aggregate demand and inflation.

Though mild inflation is an engine of growth, high inflation is a growth depressing factor .This is

mainly due to the negative impact of high inflation on investments. In India, inflation has never

been mild. Given the budget proposals on freight rates, excise duties and power tariffs, inflation

in the country will increase or stagnate at the present level. For instance, elevated Consumer

Price Index in February is a clear indication of an impending wage price spiral. Depreciation in

rupee value may import inflation. Despite the fact that core inflation has lately declined

marginallythe RBI has no control over food inflation. The first monetary policy of fiscal 2012

demonstrated the RBIs efforts to combat inflation even if it meant the need to sacrifice short-

term growth.

The RBI now needs to act via a mix of policy instruments. It has to effect changes in CRR and

resort to open-market operations. These changes must affect the quantum of liquidity, and policy

rates such as the bank rate and repo rate to influence the price of liquidity. Also the RBI should

manage its liquidity adjustment facility on a daily basis to transmit interest rate signals to the

market.

Given the macroeconomic environment of rising fiscal deficits, slow growth and price instability,

the RBI must opt for an aggressive monetary policy to increase liquidity and reduce interest

rates. A reduction in the cash reserve ratio (CRR) will be more effective than a repo rate cut to

lower borrowing costs. The repo rate is the overnight lending rate at which banks borrow money

from the RBI. Also as some heads of State-run banks recently exhorted, a 75 basis points (bps)

cut in the CRR and a 25 bps reduction in the repo rate is necessary. One basis point is one

hundredth of a percentage point. Importantly the RBI should also continue buying bonds through

its open market operations. All these moves if adopted are expected to generate growth without

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