PRESSURE POINTS

MONETARY POLICY 2006-07

Credit growth caught up with a a sharp momentum in 2004-05 and the trend continued in 2005-06. A period of credit boom presents both opportunities and challenges to policymakers.

While the surge in financial intermediation is generally associated with increased growth and efficiency, excessive credit growth often leads to some erosion in credit quality.

Policymakers, therefore, face the dilemma as to how to minimise the risks that may arise from such a decline in credit quality, while still allowing bank lending to contribute to higher growth and efficiency.

The sectoral deployment of credit serves as a useful first-hand indicator of the riskiness of banks' credit portfolio, which is crucial to any asset-liability management exercise. A major thrust to non-food credit growth has, in recent years, emanated from sectors other than agriculture and industry, particularly housing and retail loans.

In recognition of the inherent risks in high growth of retail credit, particularly the housing and personal loan segment, the Reserve Bank of India has cautioned banks about the need to sharpen their risk assessment techniques so as to guard against any adverse impact on credit quality.

INFLATION

Headline inflation remained well contained in 2005-06 despite supply-side risks including high oil prices. The year-on-year wholesale price inflation rate was 3.5 per cent on April 1 against 5.7 per cent a year ago.

RBI's target was to keep inflation in a 5.0-5.5 per cent range in 2005-06. mineral oils inflation alone contributed about 41 per cent to the headline inflation. Domestic petroleum products prices still lag the increase in international crude oil prices.

The pass-through of higher international oil prices has been restricted mainly to petrol and diesel (hike of 7-8 per cent each in June and September 2005). Domestic prices of liquefied petroleum gas (LPG) and kerosene oil remained unchanged during 2005-06.

Although fuel prices were the key driver of domestic inflation during 2005-06, As compared with an increase of about 87 per cent from $31.9 a barrel to $59.6 a barrel in prices of Indian basket of global crude oil, domestic mineral oil prices in the wholesale price index (WPI) basket increased by about 31 per cent over the same period "" petrol by 28.4 per cent and high-speed diesel by 40.1 per cent.

LIQUIDITY

The unprecedented growth in credit led to a severe liquidity crunch in the fourth quarter of 2005-06. The liquidity squeeze in turn resulted in a rise in deposit and lending rates.

During the second half of 2005-06, banks increased their deposit rates by about 75-100 basis points across various maturities. Some private sector banks increased their benchmark prime lending rates (BPLRs), while some other banks revised upwards their sub-PLR rates.

Public sector banks were unable to increase lending rates in the face of Chidambaram's urge to keep rates stable. Public sector banks raised their lending rates for fresh loans, but were unable to pass on the rise in cost of funds to existing borrowers.

Banks faced grim liquidity conditions in the face of strong credit demand and a lagging deposits growth. Banks have traditionally funded their lending operations mainly with deposits.

However, in recent years, some changes have taken place on the liability side of the banks' balance sheet. While deposits continue to be the main source of funding, the relative significance of non-deposit resources has increased.

Within non-deposit resources, the shares of borrowings and reserves in total liabilities have increased gradually. To the extent banks rely on borrowings to fund their lending operations, they are exposed to uncertainties as players in the securities market are more sensitive to interest rates and market conditions.

CURRENT ACCOUNT DEFICIT

The current account deficit widened by 127.3 per cent to $13.5 billion in April-December 2005 from $5.9 billion a year ago. The high petroleum product prices in international markets and surging imports of capital goods have raised import bill and put pressure on the current account.

According to ADB's country economic outlook, the trade deficit would grow faster than gross domestic product on the strength of growing domestic demand and high world prices.

The current account deficit is likely to slip to 3 per cent of the GDP in 2006-07. The Prime Minister's Economic Advisory Council, in a report,said the current account deficit of nearly 3 per cent for 2005-06 ws in the comfort zone, provided it was used to finance productive investment.

The council has noted that while it is appropriate for an economy of our size with vast investment needs to be running a current account deficit, its size and composition warrant continuous monitoring.

The net surplus under the invisibles account continued to remain sizeable at $28.05 billion during April-December 2005, a rise of 28.1 per cent over a year ago due to sustained growth in travel earnings and continuing pace of export of software and other business and professional services and stable remittances from overseas Indians.