"Reserve Bank of India Post Policy Conference Call for the Media"
November 2, 2010

       PANEL : DR. D. Subbarao
                     MS. Usha Thorat
                         Dr. KC Chakrabarty
                      Dr. Subir Gokarn
                               Ms. Shymala Gopinath

Thank you very much and welcome to the post policy press conference. For the last two years we have got a kind of protocol, I have a short statement which I will read out after which we will take your questions. This morning the Reserve Bank released its second quarter policy review for 2010-11. At the heart of the policy review there is further increase in the first repo rate and the reverse repo rate by 25 basis points each. Accordingly the repo rates stands rose to 6.25% and the reverse repo rate at 5.25%. There has been no change in the CRR which stands at 6% of NDPL of the banking system. With this increase since we started reversing the model policy expense in March 2010. The repo rate is increased by 150 basis points and the reverse repo rate by 200 basis points. There are always we have taken in to account both global and domestic market macroeconomic situation to in calibrating this policy move. In particular, we were guided by three considerations. 1st: Domestic growth drivers are robust which should help absorb to a large extent the negative impact of any slowdown in global recovery. 2nd: Inflation and inflationary expectations remain high as both demand side and supply side factors are at play. Given the spread and persistence of inflation, demand-side inflationary pressures need to be contained and inflationary expectations anchored. 3rd: Even though a liquidity deficit is consistent with our anti-inflation stance, it needs to be contained within a reasonable limit to ensure that economic activity is not disrupted.

To start with, a brief comment on the global economy. The fragile and uneven nature of the recovery and large unemployment in advanced economies raise concerns about the sustainability of the global turn around. The slowing momentum of recovery has prompted the central banks of some advanced economies to initiate or consider initiating a second round of quantitative easing to further stimulate private demand. While the ultra loose monetary policy of advanced economies may benefit the global economy in the medium-term, in the short-term it will trigger further capital inflows into emerging market economies and put upward pressure on global commodity prices.

Turning to domestic outlook, the economy is operating close to the trend growth rate, driven mainly by domestic factors. The normal South-West monsoon and its delayed withdrawal have boosted the prospects of both kharif and rabi agricultural production which should also stimulate rural demand. Most industrial and service sector indicators also point towards sustained growth. Taking into account the good performance of the agriculture sector, and a range of indicators of industrial production and service sector activity, the baseline projection of real GDP growth for 2010-11, for policy purposes, is retained at 8.5 per cent.

Let me now turn to the vital issue of inflation conditions. Notwithstanding some moderation in recent months, headline inflation remains significantly above its medium-term trend, and well above the comfort zone of the Reserve Bank. Food inflation has not shown the expected post-monsoon moderation and has remained persistently elevated for a year now, reflecting in part the structural demand-supply mismatches in several commodities. This has elevated inflation expectations. The risks for inflation spilling over into prices of other commodities are significant when the economy is growing close to trend. That could potentially offset the recent moderation.

Even as non-food manufacturing inflation has moderated, it remains above its medium-term trend. The new WPI series released in September 2010 is a better representative of commodity price levels with an updated base and wider coverage of commodities. When we compare the old and new WPI series, inflation at the aggregate level over the medium-term is similar under both series, but there are differences at a disaggregated level. Inflation in primary articles, especially food articles, in the new series has been significantly higher than in the old series, whereas for manufactured products, it has been somewhat lower.

Going forward, the inflation outlook will be shaped by three factors: (i) the evolution of food price inflation; (ii) global commodity prices; and (iii) demand pressures stemming from sustained growth amidst tightening capacity constraints in many industries.

On balance, inflation is expected to moderate from the present elevated level, reflecting in part, some easing of supply constraints and concerted policy action. In its July Review, the Reserve Bank made a baseline projection of WPI inflation for March 2011 of 6 per cent under the old series of WPI. The baseline projection of WPI inflation for March 2011 has been placed at 5.5 per cent under the new series. This is equivalent to 6 per cent under the old series. Effectively, this means that the Reserve Bank’s inflation projection remains unchanged from that made in its July 2010 Review.

The overall liquidity situation has been in the news over the last few weeks. Let me explain the evolving situation and the underlying dynamics. The present tight liquidity situation is a result of both structural and frictional factors. On the structural side, the deposit growth rate of the banking system has been sluggish even as the credit growth has improved. On the frictional side, the government cash balances had built up as a result of more than anticipated tax receipts. On top of it, there were large capital outflows ( on account of refund of over-subscription of Coal India IPO.

Tight liquidity conditions are admittedly desirable from the viewpoint of inflation management, but there are legitimate concerns about the deficit as the injection through the LAF window had become too large in recent weeks, in excess of the Reserve Bank’s comfort zone of +/- 1 per cent of NDTL.

With a view to alleviating the frictional liquidity pressure, the Reserve Bank decided to conduct a second LAF (SLAF) on a daily basis and also allowed banks to avail additional liquidity support under the LAF window to the extent of up to 1 per cent of their NDTL up to November 4, 2010. In order to address the structural liquidity problem, earlier today, the Reserve Bank announced an OMO for purchase of government securities amounting to Rs.12,000 Crore.

Let me now move to external sector management which has assumed a lot of importance in the recent period owing to global developments. The current account deficits in the balance of payments widened in the first quarter of 2010-11. If the current trend persists, the current account deficit as a percentage of GDP for the full year will be significantly higher than it was last year. It is generally perceived that a current account deficit above 3 per cent of GDP is difficult to sustain over the medium-term. The challenge, therefore, is to rein in the deficit over the medium-term and finance it in the short-term. The medium-term task has to receive policy focus from both the Government and the Reserve Bank. The short term task is to see that the current account is fully financed while ensuring that capital flows are not far out of line with the economy’s absorptive capacity and that the component of long-term and stable flows in the overall capital flows is high.

In the context of today’s increases in policy rates, let me now turn to another important issue. It has often been argued that the widening of interest rate differential between the domestic and international markets will result in increased debt-creating capital flows. While it is true that large interest rate differential makes investment in domestic debt instruments and external borrowings by domestic entities more attractive, we need to keep in view three aspects in the Indian context. First, the economy’s capacity to absorb capital flows has expanded as reflected in the widening of the current account deficit. Second, despite the already large differential between domestic and international interest rates, capital flows in the recent period have been predominantly in the form of portfolio flows into the equity market. This suggests that the interest rate differential is not the only factor that influences capital flows. Third, in line with our policy of preferring equity to debt-creating flows, we still maintain some controls in respect of debt flows.

Let me indicate some of the important risks to the growth and inflation outlook.

First, the main downside risk to growth emanates from the prospects of a prolonged, slow and halting recovery in advanced economies which would adversely affect the growth performance of EMEs, including India.

Second, inflationary pressures may accentuate due to the structural component in food inflation while demand side pressures may accentuate to the capacity constraints in many industries and rising global commodity prices.

Third, given the weak recovery, some advanced economies are in the process of resorting to another round of quantitative easing that could trigger capital flows into EMEs, including India. Large capital flows beyond the absorptive capacity of the economy could pose a major challenge for exchange rate and monetary management.

Fourth, the widening of the current account deficit raises concerns given the uncertainty associated with international capital flows.

Finally, asset prices in India, as in many other EMEs, have risen sharply in a short time which is a cause for concern.

How I mention three aspects of our concept today’s monetary policy actions:

First: Sustain the anti-inflationary thrust of recent monetary actions and outcomes in the face of persistent inflation risks.

Second: Rein in rising inflationary expectations which may be aggravated by the structural nature of food price increases.

Third: Be moderate enough not to stop growth. (Based purely on current growth and inflation trends, the Reserve Bank believes that the likelihood of further rate actions in the immediate future is relatively low. However, in an uncertain world, we need to be prepared to respond appropriately to shocks that may emanate from either global or domestic environment.

As it is a practice for the second quarter policy review, today’s review also contains several developmental and regulatory measures to further develop commercial markets. Promote financial inclusion; improve credit delivery and strengthening the banking system. Among the important points are a discussion paper, on pros and cons of deregulating the interest rate on savings bank deposits. Some regulatory measures relating to housing loans, such as a prescription of the loan realization. Increase in the risk weight for residence housing for loans upto Rs. 75 Lakhs and above and increasing the provisioning for all housing loans with teaser rates.

Implementing the recommendations of the Internal Group on Supervision of Financial Conglomerates.

Issuing final guidelines on compensation practices by banks by end-December 2010.
Putting the draft guidelines on licensing of new banks in public domain by end-January 2011 for public comments.

The implications for the monetary policy decisions on the regulatory and the liquidity message to discuss the meeting that have with the CEO of the Banks tomorrow. Thank you very much.

On capital flows, there is no comfort level as such but as we have said, in fact I want you all to notice that we have added in the press statement a paragraph on capital flows, which is not in the policy document because we were anticipating a lot of questions we thought we should explain them.

On capital flows, there is both pull factors and push factors and the pull factors are commonacross emerging economies, growth prospects, declining trend rates in inflation,, it is push back that is new in the emerging economies but so far this year capital flows have been roughly in line with the current account deficit unlike in 2007-2008. In 2007-2008 for example capital inflows were about 90% of GDP as against current account deficit of 1.8% of GDP. We are nowhere close to this situation because capital flows are in line with the current account deficit and the current account deficit itself has expanded; however, we have said that we want to finance current account deficit with stable flows and the endeavor going forward is to assure that the component of stable flows in the overall capital flows is high. So that answers your first question. There is no comfort level as such but we want to roughly correspond with the current account deficit. On asset prices, there are numbers of course on how much the equity prices have gone up and depending on what index we use, last year about 80% to 95%, this year about 15%, on gold about 9% to 10% last year and another 20% since first April this year, real estate housing prices there is no one index but service conducted by us on the surveys that we have studied show that real estate prices have reached or even surpassed peak crisis level in most metros, so that is where the asset prices are, there is no bubble but there is certainly asset price buildup because of a number of factors including the liquidity in the system. On housing sector we have taken measures, we have studied them because we thought that we must rein in some loose practices in play close to the housing sector, I do want to go in to the specific, but I would refer to Usha .if you want to say anything about the housing sector provisions.

Let me preface the answer to your question; I was just saying that just to put this in to perspective there have been three types of concerns against MFI sector; the first is the high rates of interest, the second is some loose practices in lending practices—loose or unhealthy practices in lending , and third is coersive practices in recovery of loans. These are the concerns that we have seen in the media as far as the MFI sector is concerned. We have as you know appointed a sub-committee according to this and one of the terms of reference across the board sub-committee is to look at this from the borrowers perspective, also to look at it from a systemic perspective whether there is any concern; I want to say that there is no implication for the stability or the financial system because the amount of the loans to MFI sector are  relatively small. At the individual bank level or at the individual bank level in a certain state or in a certain circle there might be some pressures but at a systemic level MFI issue is not likely to have any implications.. The board sub-committee has already held one meeting, I believe they are going to have another meeting later this week, they expect us to submit the report by end January and we should be able to take some action if any action is warranted.

Sir, if you can give some numbers because there are vague fears Shall we relate it separately, I do not want to just throw off a number but can we do it tomorrow?

Okay, on the first question it is not clear what the Fed action will be, how much the QE2 will be We have also heard from some market participants that in anticipation of a certain size of QE2, flows (have already come in and unless there is a surprise on the QE2 there may not be much of a change in the flows, so I cannot obviously react to hypothetical question because it depends on actions of people over which I have no control. We know what is happening around the world just as much as you do, but it is not that as if we have factored in a specific number. But we factored in not only that Fed might do something  but how our market participants might react to that.

On the liquidity situation actually that is a good question because we have set up the appropriate level for the LAF windows is) plus or minus 1% of NDTL and over the last few weeks as much as we said that has been deficit mode, it has been above the 1% limit, so we endeavor over the next few weeks it will be line with the plus/minus 1%. I enquired about how long it might take with our people and they said that we cannot put a timeframe on this but it is not going to happen quickly, so it might take a few weeks for that to adjust. It also depends on how the OMO goes, forex flows, whether we intervene or not and all those situations and including the government spending.

CRR, we did not get inputs into this split between liquidity issue and the monetary issue and so looking at CRR reduction as a possible solution to liquidity problems even while addressing the inflationary issue through a rate hike. We felt that the CRR is not really a tactical instrument, it is not something that can be used and changed when the situation changes and we believe that the liquidity situation is not long-term situation. We have also in our policy statement addressed this question that was asked earlier indicated ae zone of comfort, plus/minus 1% of NDTL and when it is outside the plan we feel that, some action needs to be taken but then you have to understand what is driving the liquidity constraint and at this point there are a number of short-term factors at play, which are much more better addressed by measures like OMO, so that is why we have chosen even in the phase of our monetary signal being, still anti-inflationary we needed to address theliquidity constraint from a little more short-term perspective.

Now the second question that you related to this, because there is a temporary tightening of liquidity short-term rates have gone up above the corridor, but to see that as a permanent phenomenon, to see that as something that will persist for a long period of time and to depend on it as a way to signal an anti-inflationary stunt ,would have been a little risky. So we want to make sure at least the policy rate is the signal and the signal sending is that we are still concerned about inflation. That signal would not have been sent by a temporarily high short-term market rate.

On transmission of monetary policy. Do you think banks still have scope to increase deposit rate or base rates to be in sync with the policy rate which was hiked by RBI since March. The other is that last year during the mid-term review the policy stance was managing crisis to recovery.(Now do you think from now onwards it is going to be more on managing the growth

Not necessarily, because it is a onetime cost. Two years ago where credit was being affected. You are saying that are you only looking at the bank credits. That is not correct.

The very fact that we look at total flow of funds to the commercial system.

No, it is actually a part of the overall managing of the requirement because under the section that banks can invest up to 30% in any company, for financial services (indiscernible) 1.2.50 and it is possible that it was needed (indiscernible) 1.2.58.

Has RBI found out some instances particularly?

It is time to recollect since how long we have been attending these monetary policy meetings and post policy conferences. I think it is since 1995.

As chief general managers we were very much a part of policy making and policy discussions, so it has been a long time, suddenly it is coming to an end, anyway it has been a great press and I think we have interacted with several people over the years and some people here are still and it is same as we used to interact with in 1994, so I think it is great to have this opportunity to be here and I am saying goodbye. Thank you Melissa.