MACROECONOMIC MANAGEMENT AND MONETARY POLICY IN INDIA

Every economy makes arrangements for its macroeconomic management through

its Central Bank, mostly by manipulating the monetary policy measures. The
nature of the policy and its thrust would depend upon the desired outcomes.
Macroeconomic management may aim at rapid growth of the economy,
facilitating or restricting the flow of credit into the economy, controlling the
interest rates in the economy and controlling the money supply in the system on
the basis of the requirements from time to time. The aim could also be to ensure
more self-employment, increasing investment and increased wage employment
opportunities. Regulation of money supply is also used as an instrument to control
the prices in the economy.

Handled by the Central Bank, Monetary Policy of a country is the primary tool for
efficient macroeconomic management. As per the advanced estimates of the
Central Statistical Organisation (CSO), the performance of the Indian economy
during 2007-08 has shown a robust growth of 8.7 per cent. Despite slight
moderation in its achievements over the previous year, the economy has
continued to grow in tune with the trends obtained during the five-year period of
2003-04 to 2007-08.

As per the advanced estimates, total foodgrain production during the year 2007-
08 is expected to reach all time high of 227.3 million tonnes, recording an
increase of 4.6 per cent over the previous year’s production, thus exceeding the
targets. During the same year, the index of industrial production rose by 8.7 per
cent and the manufacturing sector recorded even higher growth rate of around 9
per cent. Infrastructure sector, however, disappointed and grew at the rate of 5.6
per cent. But the services sector surged ahead with its double digit growth at 10.6
per cent, despite some moderation in its pace and continued to be the major
contributor to the GDP growth.

Despite the slight slowdown in most of the sectors, the process of fiscal correction
and consolidation under the Fiscal Responsibility and Budget Management
(FRBM) Act continued. The Revised Estimates (RE) for the year 2007-08 placed the
revenue deficit and Gross Fiscal Deficit (GFD) at 1.4 per cent and 3.1 per cent of
GDP, respectively, which were lower than the budget estimates, both in absolute
as well as relative terms. The Union Budget for 2008-09 also proposes to continue
the fiscal consolidation process with the key deficit indicators like revenue deficit
and GFD, budgeted to be lower by 0.4-0.6 percentage points and primary surplus
higher by 0.5 percentage points of GDP in 2008-09 than in the previous year.
While the FRBM targets relating to GFD are set to be achieved in accordance with
the mandate, the Budget proposes to reschedule the stipulated target of zero
revenue deficit by 2008-09.

Worrisome Future

On April 28, 2008 the Reserve Bank of India (RBI) released a document,
“Macroeconomic and Monetary Developments in 2007-08”, to serve as
background to the Annual Policy Statement for 2008-09. It noted with concern
that during the second half of the year 2007-08, the combined effect of the higher
food and fuel prices, coupled with strong demand conditions, especially in the
emerging economies like India, would result in pressure on the price level. The
report also pointed out that the monetary policy responses during the year were
mixed in view of growing concerns about the implications of credit crunch arising
out of the US sub-prime crisis. The government reacted with caution to ensure
that the price control measures may not result in depressed economic growth of
the economy. But the situation worsened with the global crude oil prices
burgeoning beyond expectations, crossing $135 per barrel by the last week of
May 2008.

Global financial markets also remained volatile during the latter part of the
previous financial year, as the US sub-prime crisis spilled over from mortgage and
credit markets to other assets. Resultantly, the Indian financial markets, after
remaining stable and buoyant upto December 2007, suffered bouts of volatility
towards the second week of January 2008. In the foreign exchange market the
Indian rupee generally exhibited two-way movements against major foreign
currencies.

The external sector, by and large, remained within the comfort zone and offered
some spark. India’s balance of payments position also remained comfortable
during 2007-08 (April-December). The merchandise trade deficit widened to US
$66.5 billion in April-December 2007, from US $50.3 billion in April-December
2006. Net surplus under invisibles (services, transfers and income taken together)
was higher at US $50.5 billion in April-December 2007 as compared to US $36.3
billion. Despite sharp rise in merchandise trade deficit, the net invisible surplus,
mainly resulting from the rise in remittances from the overseas Indians and
software services exports, contained the current account deficit in trade at US
$16.0 billion during April-December 2007, as against US $14.0 billion in April-
December 2006.

The Third Quarter Review of January 29, 2008 had noted with concern the
unfolding of unfavourable global developments and the responses of monetary
authorities which seemed to provide an indication of threat to growth and
financial stability worldwide. Consequently, developments in global financial
markets in the context of the US sub-prime crisis required more intensified
monitoring and quick responses with all available instruments, to preserve and
maintain macroeconomic and financial stability of the economy. In addition, risks
associated with high and volatile international prices of fuel, food and metal
prices intensified, complicating the task of the policy in maintaining the right
quantum of liquidity and solvency in the financial markets and institutions.

Against this background, it was realised by the Reserve Bank of India that
Monetary Policy had to be vigilant and proactive in protecting the real economy
from excess volatility in financial markets, while at the same time understanding
well that the country cannot be totally immune to global developments.

In view of the unprecedented economic complexities there were certain key

factors that determined the direction of the Monetary Policy for 2008-09. Firstly,
there was an immediate challenge of northward movement of food and energy
prices which possibly contains some structural components. Secondly, while
demand pressures continue, there has been some improvement in the domestic
supply response, alongside a build-up of additional capacities enabled by a
conducive policy environment. Accordingly, even as investment demand
continues to be high, elasticity of supplies can be expected to improve further and
new capacities should surface in near future. Thirdly, the monetary policy in the
recent years has been aiming at the outcomes relating to growth and stability,
barring the recent episodes of external shocks. Thus, the monetary policy
measures undertaken since September 2004 continue to have stabilising effect
on the economy.

Measures relating to the cash reserve ratio, and recent initiatives with regard to
supply-management are giving favourable results, while a more reliable
assessment of crop prospects by the government is also underway. Critical to the
monetary policy is the importance of expectations relating to both global and
domestic developments. While monetary policy has to respond urgently to
immediate concerns with respect to the requirements of overall macroeconomic
management, it cannot afford to ignore the considerations for the immediate
future prospects and expected developments. At the same time, it was important
to demonstrate on a sustainable basis, a determination to act decisively,
effectively and swiftly to allay the fears with regard to increasing pressures of
price rise.

In view of the above pressing uncertainties and confusing dilemmas, it was

considered necessary to take well considered decisions with regard to the timing
and magnitude of policy actions on sustained basis. As a result, the RBI decided to
continue with its well tested policy of active demand and liquidity management
through proper use of the CRR stipulations and open market operations, and by
utilising judicially all the policy instruments at its disposal.

Excluding the possibility of any adverse and unexpected developments in various

sectors of the economy, assuming that capital flows are effectively managed and
keeping in view the outlook for growth and inflation in the Indian economy, the
overall focus of the Monetary Policy in 2008-09 aimed at ensuring a
macroeconomic environment that accorded high priority to price stability, firm
projections of inflation, favourable conditions in financial markets and other
conditions conducive to continuation of high and sustainable growth rate in the
economy. The Monetary Policy also aims at quickly responding to the ongoing
adverse global developments on sustainable basis, as also to the domestic
situation resulted by the apprehensions about the inflation, financial stability and
growth momentum, with both conventional and non-conventional measures. The
Policy also emphasizes the need for a good credit quality, as well as credit
delivery, particularly for employment-intensive sectors while ensuring financial
inclusion of the masses.

The broader aim is to achieve high growth rate, controlled prices and burgeoning
foreign trade. Instead of being rigid with its measures, the RBI has been using
flexibility as the centre-stone of its macroeconomic management framework. All
the policy measures may not be able to yield the expected results, but these
measures do impact the economy positively. As the Monetary Policy measures
alone may prove inadequate to achieve the perfect macroeconomic
management, such measures are also expected to be supplemented by
appropriate fiscal policy measures.