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Monetary policy 2006-07: Mid-term review

Oct 31, 2006

The Reserve Bank of India (RBI) has announced its mid-term review of the annual monetary policy for 2006-07. The central bank, while keeping the bank rate and reverse repo rates stable at 6%, has raised the repo rate by 25 basis points (0.25%) to 7.25%. The overall stance of the mid-term policy is outlined as follows:

  • To ensure a monetary and interest rate environment that supports export and investment demand in the economy - so as to enable continuation of the growth momentum while reinforcing price stability, with a view to anchoring inflation expectations.

  • To maintain the emphasis on macroeconomic and, in particular, financial stability.

  • To consider promptly all possible measures as are appropriate to the evolving global and domestic situation.

The overall assessment
The central bank has notified of the strength of the Indian economic engine, through inferences like strong momentum in industrial production, continued bright prospects in the services sector, and strengthening demand for credit for investment and consumption purposes. As a consequence of this, the demand for bank credit has witnessed a strong growth of over 30% YoY for the third year in succession, mainly led by credit extended to fast growing sectors such as housing, commercial real estate and retail loans.

Against this background, the RBI has also sounded alarm bells 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, and this is clearly visible in the Indian economy at present, for which the RBI has shown its concerns, thereby raising the repo rate (the rate at which it infuses money in the system by lending to banks for the short-term).

As part of this mid-term review, the RBI has also talked of increasing difficulty in the global economy with respect to identifying the symptoms of overheating. It states that, "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."

On Basel II compliance for banks
The mid-term review contains a special mention of the impending Basel II compliance for banks operating in India. Against the earlier scheduled adoption date of March 31, 2007, and now taking into account the state of preparedness of the banking system, the RBI has decided to provide banks some more time to put in place appropriate systems so as to ensure full compliance with Basel II. While foreign banks operating in India and Indian banks having presence outside India will have to migrate to the new rules with effect from March 31, 2008, all other scheduled commercial banks can defer the same to March 31, 2009.

What to expect?
Like in the earlier policy reviews in April and July, this times around as well, the RBI has stated that its objective will be to continue to maintain conditions of stability (inflation) that contribute to sustaining the momentum of growth on a long-term basis. Towards this objective, it will continue to play a rebalancing and adjustment game the way the situation at the domestic and global level demands.

Overall, the mid-term review of the monetary policy has been on expected lines. The RBIs GDP growth forecast of 8% in FY07 with inflation at 5% to 5.5% are positives for the economy as a whole. But for some caution on the quality of credit disbursals and concerns with respect to global economic developments, investors have nothing significant to worry about at the macro level.

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