2.39 Due to persistent fiscal deficits, the combined outstanding liabilities of the Centre and the State Governments (as a ratio to GDP) have been rising since mid-1990s (Table 2.22). This ratio is expected to increase further by around one percentage point during 2004-05 and is estimated to reach 77.5 per cent as at March 2005. The high level of debt of the Centre as well as the State Governments has resulted in a sizeable increase in interest payments, notwithstanding the softening of interest rate regime in recent years.

2.40 The Annual Policy Statement of May 2004 had indicated that, barring the emergence of any adverse and unexpected developments in the various sectors of the economy and assuming that the underlying inflationary situation does not turn adverse, the overall stance of monetary policy for 2004-05 will be:

• Provision of adequate liquidity to meet credit growth and support investment and export demand in the economy while keeping a very close watch on the movements in the price level.
• Consistent with the above, while continuing with the status quo, to pursue an interest rate environment that is conducive to maintaining the momentum of growth and, macroeconomic and price stability.

2.41 Consistent with the expected growth and inflation rates, the Annual Policy Statement placed the growth in broad money (M 3) and non-food credit(including non-SLR investments) at 14.0 per cent and 16.0-16.5 per cent, respectively, for 2004-05. The projection for non-food bank credit (including non SLR investments) growth during the year was revised upwards to around 19.0 per cent in the Mid-Term Review of October 2004. It was felt that the higher credit expansion could be accommodated without putting undue pressure on money supply because of the lower borrowing of the Government from the banking sector. In the eventuality of Government borrowings being larger, unwinding of MSS would facilitate such borrowings. Monetary management in the first half of 2004-05 was conducted broadly in conformity with the monetary policy stance announced in the Annual Policy Statement. In monetary management, the Reserve Bank faced challenges on two counts: overhang of liquidity and the surge in headline inflation. Accordingly, the Reserve Bank undertook calibrated measures. On a review of liquidity conditions, the Cash Reserve Ratio (CRR) was raised by 50 basis points to 5.0 per cent in two stages effective September 18, 2004 and October 2, 2004, even as the Reserve Bank indicated that it will continue to pursue its medium-term objective of reducing CRR to its statutory minimum of 3.0 per cent. This measure reduced the liquidity in the banking system by about Rs.9,000 crore. The Reserve Bank chose to increase the CRR, partly for absorbing liquidity in the system, but more importantly for signalling the Reserve Bank's concern at the unacceptable levels of inflation so that inflationary expectations are moderated while reiterating the importance of stability in financial market conditions. On the interest rate front, the Bank Rate was kept unchanged at 6.0 per cent. However, the fixed repo (now called reverse repo in accordance with international practice) rate was increased, effective October 27, 2004, by 25 basis points to 4.75 per cent.

2.42 The overall stance of monetary policy for the second half of 2004-05, as the Mid-Term Review indicated, barring the emergence of any adverse and unexpected developments in the various sectors of the economy and keeping in view the inflationary situation, will be:

• Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.
• Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.
• To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

2.43 Reserve money growth during the current fiscal year 2004-05 (up to December 10, 2004), as in the past few years, primarily emanated from the accretion to the Reserve Bank's foreign currency assets (Table 2.23 and Chart II.9).

On March 25, 2004 the Government of India signed a Memorandum of Understanding (MoU) with the Reserve Bank of India detailing the rationale and operational modalities of the Market Stabilisation Scheme (MSS). The scheme came into effect from April 1, 2004. The ceiling on the outstanding amount under MSS was fixed initially at Rs.60,000 crore which was, however, subject to an upward revision based on the liquidity assessment. The ceiling has been since enhanced to Rs.80,000 crore. An indicative schedule for the issuance of Treasury Bills/ dated securities under the MSS for the first quarter of the 2004-05 (April 1, 2004-June 30, 2004) was also announced to provide transparency and stability in the financial markets. It was proposed to issue an aggregate of Rs.35,500 crore (face value) of Treasury Bills/ dated securities under the MSS during the first quarter of 2004-05. As against this, Rs.39,730 crore was issued during the first quarter reflecting an unscheduled auction of dated securities amounting to Rs.5,000 crore on April 8, 2004 and acceptance of bids amounting to Rs.230 crore (as against the notified amount of Rs.1,000 crore in respect of 364-day Treasury Bills on June 23, 2004). The MSS schedule for the second quarter was issued on June 29, 2004 which indicated issuances of Rs. 36,500 crore (inclusive of rolling over of Rs.19,500 crore under 91-day Treasury Bills issued during the first quarter). On September 29, 2004, an indicative calendar for MSS issuances of Rs.25,500 crore was announced (including of rolling over of Rs.16,955 crore under 91-day Treasury Bills maturing during the quarter).

2.44 The expansionary effect of forex purchases was neutralised through sterilisation operations. These operations were greatly facilitated by the introduction of the Market Stabilisation Scheme (MSS) in April 2004 to absorb liquidity of a more enduring nature (Box II.1). With the introduction of the MSS, the amounts tendered under the Liquidity Adjustment Facility (LAF) declined from an average of Rs.70,523 crore in April 2004 to Rs.10,805 crore in October 2004. There was, however, a net injection of Rs. 5,066 crore in November 2004. During the first quarter of 2004-05, sterilisation was done primarily through the MSS. In the second quarter (July-September), capital flows tapered off. In the subsequent period (October 2004 onwards), the revival of capital inflows in November were mainly offset by the seasonal pick up in cash demand (Table 2.24 and Chart II.10). The total stock of Treasury Bills and dated securities issued under the MSS amounted to Rs.51,334 crore as on December 10, 2004 inclusive of Rs.25,000 crore raised through dated securities with a residual maturity of upto two years. In addition to the MSS and LAF operations, surplus balances in the Central Government account with the Reserve Bank also helped in draining out excess liquidity from time to time.

2.46 As on November 26, 2004, the year-on-year growth in broad money (M3) was 13.5 per cent (net of the impact of the conversion of a non-banking entity into a banking entity) as compared with 12.4 per cent in the preceding year (Table 2.26). The year-on-year growth rate in was consistent with the M3 indicative trajectory of 14.0 per cent. Both currency and aggregate deposits recorded a strong growth (Chart II.11).

2.47 A positive feature of the current year has been the sharp increase in commercial credit off-take reflecting, inter alia, the strong industrial performance (Table 2.27 and Chart II.12). The pickup in scheduled commercial banks’ non-food credit

growth at 9.5 per cent during the first half of the year was, in fact, the highest in the 1990s aided partially due to base effects. Food credit reversed its declining trend of the previous year, reflecting higher procurement and lower off-take operations. In the face of the pick-up in credit demand, banks reduced their investments in government securities. Year-on-year growth of banks’ investment in

2.48 Data on sectoral deployment show that priority sector continued to be the largest recipient of bank credit largely driven by the demand for housing loans below Rs.10 lakh. A noteworthy aspect is the turnaround in industrial credit. This was dominated by two sectors, viz., infrastructure and petroleum, which accounted for as much as 86 per cent of the incremental off-take during April-September 2004. Credit off-take declined for industries such as coal, mining, sugar, tobacco and tobacco products, petro chemicals and computer software. Growth in credit to the housing sector continued to be strong and accelerated even further (Table 2.28).

2.49 The pick-up in industrial credit was supplemented by an increased recourse to external commercial borrowings (Table 2.29). In addition, improved corporate profitability and other internal sources remained a key source of funds for the industry.

2.50 Reflecting the higher credit off-take, the excess liquid funds with the commercial banks have recorded a sustained decline since August 2004.

Moderation in capital flows in the first-half of the year and the increase in the CRR also contributed to the reduction in excess liquid funds.

Concomitantly, secondary market yields of Government securities increased across the maturity spectrum (Chart II.13). Reflecting these factors, some banks have raised their deposit rates and housing loan rates (Table 2.30).

2.51 Inflation is hardening worldwide, albeit from fairly low levels, on the back of elevated commodity, especially fuel, prices. Commodity prices have been driven by increased demand emanating from the global economic recovery led by the strong expansion of the Chinese economy. Although the base effects are beginning to moderate the metals price inflation, fuel prices have been quite volatile. Fuel prices hit their highest level in October 2004 crossing US $ 55 per barrel, amidst concerns over oil supply bottlenecks, low inventories, and very low spare output capacity as well as nervous market sentiment (Chart II.14). The increase in producer prices is beginning to pull up consumer price inflation in many countries, especially as exhaustion of slack available in capacity utilisation is now forcing producers to pass on higher input costs to consumers (Table 2.31 and Chart II.15).

2.52 Central banks in a number of economies have, therefore, star ted withdrawing their accommodative stance by raising key policy rates in a measured manner to stabilise inflationar y expectations and yet at the same time support economic recovery. The Federal Open Market