Second Quarter Review of Monetary Policy 2013-14


Dr. Raghuram G. Rajan


Part A. Monetary Policy

Monetary and Liquidity Measures

Following an assessment of the evolving macroeconomic situation, the Reserve Bank has decided to:

· reduce the marginal standing facility (MSF) rate by 25 basis points from 9.0 per cent to 8.75 per cent with immediate effect;

· increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 7.5 per cent to 7.75 per cent with immediate effect

· keep cash reserve ratio (CRR) unchanged at 4.0 per cent of net demand and time liability (NDTL); and

· increase the liquidity provided through term repos of 7-day and 14-day tenor from 0.25 per cent of NDTL of the banking system to 0.5 per cent with immediate effect.

Consequently, the reverse repo rate under the LAF stands adjusted to 6.75 per cent and the Bank Rate stands reduced to 8.75 per cent with immediate effect. With these changes, the MSF rate and the Bank Rate are recalibrated to 100 basis points above the repo rate.


  1. Since the Mid-Quarter Review in September, the outlook for global growth has improved modestly, with fiscal concerns abating in the US and lead indicators of activity firming up in the Euro area and the UK.

  2. In emerging and developing economies, the prospect of delay in the taper of the Federal Reserve''s bond purchases has brought calm to financial markets, and capital flows have resumed. Nevertheless, headwinds to growth from domestic constraints continue to pose downside risks, and vulnerabilities to sudden shifts in the external environment remain.

  3. In India, industrial activity has weakened, with a contraction in consumer durables and tepid growth in capital goods reflecting the ongoing downturn in both consumption and investment demand. Strengthening export growth and signs of revival in some services, along with the expected pick-up in agriculture, could support an increase in growth in the second half of 2013-14 relative to the first half, raising real GDP growth from 4.4 per cent in Q1 to a central estimate of 5.0 per cent for the year as a whole (Chart 1). The revival of large stalled projects and the pipeline cleared by the Cabinet Committee on Investment may buoy investment and overall activity towards the close of the year.

  4. In the meantime, with many large entities holding back on payments, liquidity pressures are building up on small and medium enterprises. A number are facing conditions of financial distress. Remedies partly lie in the speed-up of government and public sector payments, and on measures to channel credit to small and medium enterprises.

  5. Inflation measured by the wholesale price index (WPI) rose in September for the fourth month in succession. The pass-through of rupee depreciation into prices of manufactured products is acting, along with elevated food and fuel inflation, to offset possible disinflationary effects of low growth. While food price pressures may ease with the arrival of the kharif harvest and the usual seasonal moderation, overall WPI inflation is expected to remain higher than current levels through most of the remaining part of the year (Chart 2), warranting an appropriate policy response.

  6. Retail inflation measured by the consumer price index (CPI) has also risen sharply across food and non-food constituents, including services, keeping inflation expectations high. Notwithstanding the expected edging down of food inflation, retail inflation is likely to remain around or even above 9 per cent (Chart 3) in the months ahead, absent policy action.

  7. Liquidity management has been calibrated to the system''s requirements arising from the sharp pick-up in credit relative to deposit growth and festival-related demand for currency. Liquidity up to 0.5 per cent of bank-wise NDTL is available through overnight LAF repos. Furthermore, export credit refinance of up to 50 per cent of eligible export credit outstanding amounts to approximately 0.5 per cent of system-level NDTL. To provide market participants with additional access to primary liquidity, as well as greater flexibility in managing reserve requirements, term repos of 7-day and 14-day tenor have been introduced to provide liquidity equivalent to 0.25 per cent of NDTL. As a result of the measures taken by the Reserve Bank to ease liquidity, the average drawal on the MSF has declined significantly from about `1.4 trillion in mid-September to `0.4 trillion by mid-October, and money market rates have fallen by 125 basis points. Going forward, however, the more durable strategy for mitigating mismatches between the supply of, and demand for, funds is for banks to step up efforts to mobilise deposits.

  8. As regards the external sector, the improvement in export performance over the last two months, coupled with the contraction in non-oil import demand, has enabled a perceptible narrowing of the trade deficit with favourable implications for the current account deficit (CAD) going forward. Policy interventions have bridged the external financing gap. These factors have brought some calm to the foreign exchange market. However, normalcy will be restored to the exchange market only when the demand for dollars from public sector oil marketing companies is fully returned to the market.

    Policy Stance and Rationale

  9. From September, as steps to contain the CAD started taking effect in an improving external environment, volatility in the foreign exchange market ebbed and it became possible to unwind the exceptional liquidity tightening measures. Keeping in view the need to infuse liquidity into the system to normalise liquidity conditions, term repos will now be conducted for a total notified amount equivalent to 0.5 per cent of NDTL of the banking system. In addition, the MSF rate will be reduced by 25 basis points.

  10. With the more...

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