THE ANNUAL REPORT ON THE WORKING OF THE RESERVE BANK OF INDIA

For the Year July 1, 2008 to June 30, 2009*

PART ONE : THE ECONOMY - REVIEW AND PROSPECTS

I ASSESSMENT AND PROSPECTS

The Indian economy exhibited significant resilience in 2008-09 in the face of an intense global
financial crisis and the subsequent severe global recession. The contagion from the global crisis,
however, posed the challenge of responding to the evolving risks and heightened uncertainties, which
warranted swift and appropriate use of fiscal and monetary policy measures with a view to ensuring
orderly functioning of the markets, preserving financial stability, and moderating the dampening
effects on growth. For the Government, this involved temporary deviation from the fiscal consolidation
process embodied in the Fiscal Responsibility and Budget Management (FRBM) Act. The Reserve
Bank had to contend with the challenges over two distinct phases during the year, which required
contrasting monetary policy responses. In the first half of the year, inflation firmed up under the
pressure of hardening international commodity and food prices, which necessitated an anti-
inflationary policy response. In the second half, however, restoring orderly conditions in the market
and subsequently supporting the growth momentum emerged as the key challenges. This required
adoption of accommodative monetary policy stance, which was reflected in the provision of ample
liquidity at lower interest rates. Consequently, the financial system functioned without disruptions
and credit conditions did not operate as a constraint to growth.

Reverting to the high growth trajectory at the earliest remains the key policy challenge in the near
to medium-term. The sustained expansionary fiscal and monetary policy stances, however, entail
the risk of aiding inflationary pressures in the near-term and constraining the growth process in
the medium-run. Timely exit from the current policy stance, thus, would be critical, given the
emerging signs of inflationary pressures. Credible action plan on fiscal consolidation, with an
emphasis on the quality of fiscal adjustment driven by rationalisation of expenditure and efficiency
of public services would be necessary to revert to the high growth trajectory. The adverse impact of
deficient monsoon on growth, inflation and social security needs to be carefully managed. Policies
conducive to high domestic savings and promoting the role of innovations, technology and reforms
in enhancing the productivity of investment may have to receive greater attention. The financial
stability framework would need to be strengthened further taking into account the lessons from
the global financial crisis.

* : While the Reserve Bank of India’s accounting year is July-June, data on a number of variables are available on a financial year basis,
i.e., April-March, and hence, the data are analysed on the basis of the financial year. Where available, the data have been updated
beyond March 2009. For the purpose of analysis and for providing proper perspective on policies, reference to past years as also
prospective periods, wherever necessary, has been made in this Report.

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 ANNUAL REPORT

I.1 The Indian economy witnessed moderation on food pr ices, notwithstanding the record
in growth in 2008-09 in comparison with the robust foodgrains production in 2008-09 and the high
growth performance in the preceding five years. The buffer stocks, also indicates upside risks to inflation,
deceleration in growth was broad based across besides the evidence from the Reserve Bank’s
three major constituent segments of GDP, i.e. Sur vey of inflation expectations suggesting
agriculture, industry and services. Moreover, increase in inflation over the coming three months
deceleration in industry and services sector also to one year. The First Quarter Review of Monetary
persisted over four consecutive quarters of the year. Policy for 2009-10 took into account the emerging
Reflecting the contraction in global demand, outlook on inflation and revised the inflation
exports declined. Domestic aggregate demand also projection upwards from the earlier 4.0 per cent to
moderated due to sharp deceleration in the growth 5.0 per cent, while reiterating 3.0 per cent as the
of private consumption demand. Reflecting the medium term inflation objective.
expansionar y fiscal policy response to the
slowdown in growth, government consumption I.2 The Indian economy exhibited five
demand increased by 20.2 per cent, and the successive years of high growth with moderate
contr ibution of gover nment consumption inflation and macroeconomic stability during 2003-
expenditure to overall growth accordingly increased 08, before encountering the contagion from the
to 32.5 per cent from an average contribution of global economic crisis in 2008-09. The average
5.9 per cent in the preceding five years. Corporate GDP growth of 8.8 per cent achieved during this
performance remained dampened, with significant phase was not only the highest ever recorded in
fall in sales growth in the second half of the year, India’s post independence economic history, but
and decline in profits in last three consecutive also one of the highest in the world in the recent
quarters of the year. In 2009-10 so far, emerging period. More importantly, inflation in India averaged
signs of recovery are yet to indicate any clear trend, at about 5.3 per cent during this period. The
and the deficient monsoon and the depressed macroeconomic environment remained stable and
export performance have to be seen along with the resilient to external shocks, despite rising degree
improving growth in core infrastructure sector, of openness and significant reforms. India’s ascent
recovering industrial production and more optimistic as a major emerging market economy with high
business outlook. Recognising the balance of risks potential for sustained robust growth was reflected
to growth, the First Quarter Review of Monetary in surges in capital inflows, which were in excess
Policy for 2009-10 placed the projection for GDP of the external financing needs as conditioned by
growth at 6.0 per cent, with an upward bias. The the country’s prudent emphasis on sustainable
inflation environment remained highly volatile during current account deficit as a means to stable growth.
2008-09; WPI inflation rose to a high of 12.9 per The impetus for growth emanated from the upsurge
cent in August 2008 and declined sharply thereafter in the domestic savings rate from 23.5 per cent of
to below 1 per cent by the end of the year, before GDP in 2001-02 to 37.7 per cent in 2007-08, which
turning negative since June 2009. The currently facilitated the step up in investment rate from 22.8
observed negative inflation essentially reflects the per cent to 39.1 per cent during the corresponding
impact of the high base of the previous year, and per iod. Fiscal consolidation and refor ms
this transitory trend may not persist beyond few unshackled the constraints to realisation of
months. Within WPI, essential commodities productivity and efficiency driven growth. Before the
continue to exhibit high inflation. Moreover, inflation emergence of the global economic crisis in 2008-
expectations have not abated as much as the 09, the high growth trajectory was generally seen
overall decline in WPI inflation, and inflation as per as the sustainable cr itical threshold, and
different consumer price indices remain stubbornly accordingly the policy focus was primarily shifting
high. The adverse impact of the deficient monsoon to address the growing infrastructure deficit and

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 ASSESSMENT AND PROSPECTS

make progress on remaining areas of reforms, while prices, and there was a return of inflation after a
also ensuring that the growth process becomes phase of “great moderation”. Dealing with supply
more inclusive. side sources of inflation posed significant
challenges for the conduct of Reserve Bank’s
I.3 The Indian economy confronted one of the monetary policy, particularly in the face of emerging
severest external shocks in 2008-09 in the form of signs of cyclical slowdown on the one hand and
an intense global financial crisis coupled with a the risk of spiralling headline inflation affecting
global recession, but exhibited notable resilience, inflation expectations on the other. In the second
with GDP growth at 6.7 per cent. Orderly conditions half of the year, the global financial crisis and the
prevailed in various segments of the financial subsequent global recession changed dramatically
system during the year. The cyclical growth the nature of the challenge emanating from
deceleration witnessed in the first half of 2008-09 globalisation. The sharp swings in global conditions
got amplified in the second half of the year on within the year were reflected in the fast slide of
account of the dampening effects of the global the world economy into a deep recession from a
recession. This happened notwithstanding the phase of high growth over the preceding four
policy driven moderation in the adverse effects of consecutive years. There was a sudden plunge to
the contagion on the economy. When the global dysfunctional markets from a phase of growing
markets turned dysfunctional in September 2008, market bubbles that had brought down risk
with intense scramble for liquidity and subsequent premiums to historic low levels. Post-September
credit freeze under the pressure of deleveraging, 2008, developments in the financial systems of
the Indian markets reverberated the shock, which advanced countries revealed that irrespective of the
was seen in the form of higher volatility in all degree of globalisation of a country and the
segments of the financial markets and sharp soundness of its domestic policies, a global crisis
corrections in stock prices. The macro-financial could spread to every economy. The contagion
conditions remained exceptionally challenging from could transmit through sagging consumer and
the stand point of the conduct of Reserve Bank’s business confidence, which, in the current context,
policies, as it had to respond to multiple challenges, is turning out to be more critical than the contagion
starting from containment of inflation in the first half transmitted through trade and capital flows. The
of the year to containing the deceleration in growth, international transmission of liquidity shocks was
preser ving the soundness of the banks and fast and unprecedented; while falling asset prices
financial institutions, ensuring normal functioning and uncertainty about valuation of the traded
of the credit market and maintaining orderly instruments affected market liquidity, failure of
conditions in the financial markets in the second leading global financial institutions and the
half. At times, the Bank had to operate on multiple deleveraging process tightened the market for
fronts simultaneously, and in constant consultation funding liquidity. Given the growing risk of illiquidity
and coordination with the Government, with the cascading into solvency problems, liquidity
overriding objective of limiting the adverse effects management acquired priority in most central
of the global crisis to the extent possible. banks, since it was critical for preserving normalcy
in financial markets, and thereby avoiding the risk
I.4 Global developments prominently
of snowballing effects of financial stress on the real
influenced domestic developments in 2008-09.
economy.
There were two distinct phases during which the
transmission of global shocks posed different but I.5 The Reserve Bank could restore normalcy
significant challenges for the Reserve Bank. In the in the financial markets over a short time period
first half of the year, the world experienced through its liquidity operations in both domestic
simultaneous increase in both food and commodity currency and foreign currency; the absence of any

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direct exposure of the Indian banks and financial financial system for taking positions in the troubled
institutions to the troubled assets and failing assets in the advanced economies. Despite
financial institutions in the advanced countries significant financial sector reforms, adequate
helped in the avoidance of any serious stress in regulatory precautions have ensured that complex
the financial system. The financial crisis in the structures like synthetic securitisations do not
advanced countries, however, precipitated into an contaminate the Indian markets, and prudential
intense synchronised global recession, which measures also limit the exposure of the banking
impacted the growth prospects of all countries system to sensitive sectors and asset price bubbles.
through contraction in aggregate demand. With the Absence of structured products that could mask
earlier perception of decoupling fast turning out to risk exposures, hide interconnectivity of market
be a myth, moderating the adverse effects of the operators and allow excessive use of leveraged
contagion on growth emerged as a major speculation has been a notable aspect of the
globalisation-induced challenge in the second half Reserve Bank’s prudence in regulation. Reserve
of the year. The severity of the external shock had Bank’s mandatory SLR requirement of 25 per cent
emerged as a test for the capacity of public policies (now reduced to 24 per cent) also appeared
to ensure soft landing in the face of persistent relevant in the context of sharp deterioration in
adverse global economic conditions. asset quality that was experienced by the leading
international banks and financial institutions. More
I.6 India’s capacity to withstand the global
importantly, appropriate countercyclical regulations
shock better than many other emerging market
and provisioning requirements also contributed to
economies was partly on account of the sound
preventing development of asset price bubbles in
macroeconomic and financial sector policy
India.
environment that had been put in place in the post-
reform period by careful assessment of the I.7 The Reserve Bank had taken measures to
opportunities and risks associated with reforms. modulate the monetary overhang that was building
After the balance of payments crisis in the early on account of sustained expansion in money
1990s, as a matter of concerted policy effort, the growth; the withdrawal of monetary accommodation
extent of dependence on external finance for had in fact started in 2004 with gradual increase in
financing domestic growth has been limited to the both repo and reverse repo rates. Since April 2005
sustainable level of the current account deficit, and the Bank had also been expressing its concerns
capital flows in excess of the financing needs have over the fast growth in credit, and the overdrawn
resulted in comfortable foreign exchange reserves. state of the banking system to sustain the credit
The reserve management policy also assumes disbursement, given the mismatches between
importance in the context of the market determined sources and uses of funds, and the associated
exchange rate regime where the Reserve Bank increase in the credit-deposit ratios for certain
aims at containing undue volatility, recognising the banks. Recognising the unprecedented credit
adverse effects of a volatile exchange rate on trade, growth to the real estate sector during 2004-07,
investment and growth. Despite significant the provisioning requirements and risk weights
pressures on India’s balance of payments in the were increased to prevent a build up of asset
third quarter of the year, the foreign exchange bubble. Absence of any sovereign issue in the
reserves facilitated Reserve Bank’s operations in international markets for financing the deficit of the
the foreign exchange market to preserve orderly Government has also helped in limiting the effects
conditions, notwithstanding a phase of high volatility of adverse external shocks on the macroeconomic
over a short period of time. The gradual and policy environment of the country. A large domestic
sequential approach to liberalisation of the capital market, reliance on domestic demand and domestic
account also prevented leveraging of the Indian savings for growth, comfortable foreign exchange

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 ASSESSMENT AND PROSPECTS

reserves, prudent management of the capital public sector demand, both consumption and
account and a sound and resilient domestic investment, to ensure a credible deterrent to
financial system, thus, represent the key factors that deceleration in growth. Due to the global recession,
helped in moderating the impact of the contagion contracting external demand also affected export
on India in relation to many other countries around growth, which first decelerated, and then declined.
the world. The moderation in growth in 2008-09 was thus
broad-based, spread across all three sectors (i.e.
I.8 The deceleration in growth from an average
agriculture, industry and services) of the economy.
of 8.8 per cent during 2003-08 to 6.7 per cent in
The decline in growth in agriculture and industry,
2008-09, however, warranted swift and
however, was more prominent compared to
comprehensive policy response, given the
services. A major cause for policy concern was
overriding policy focus of maintaining a growth rate
dampened growth in the Index of Industrial
of around 9 per cent as the key means to ensure
Production (IIP) since November 2008 with
higher living standards for all in an inclusive growth
negative growth in one month, besides the
process. As the post-September 2008 global
sustained fall in exports since October 2008.
developments affected the Indian markets through
Reflecting the demand augmenting policy, the
the global liquidity spiral and sharp spurt in risk
growth in gover nment final consumption
aversion, the Reserve Bank had to operate in
expenditure increased sharply by 20.2 per cent in
several markets simultaneously, with the use of
2008-09 as compared with 7.4 per cent in 2007-
conventional and unconventional measures, given
08. The contribution of the government consumption
the overriding aim of restoring orderly market
demand to growth, as a result, increased from 8.0
conditions and preserving smooth flow of credit for
per cent in 2007-08 to as high as 32.5 per cent in
all productive purposes.
2008-09.

ASSESSMENT OF 2008-09
The Fiscal Stance
Economic Growth
I.10 The unprecedented magnitude and
I.9 The deceleration in growth, which started complexity of the challenge necessitated temporary
with the cyclical slowdown in the first half of deviation from the fiscal consolidation process
2008-09, got magnified in the second half due to embodied in the Fiscal Responsibility and Budget
the contagion from the global crisis. Deceleration Management (FRBM) Act. The deviation from the
in growth to 5.8 per cent in two successive quarters fiscal consolidation path was evident from the
in the second half of 2008-09 represented the revision to the Centre’s fiscal deficit target from 2.5
weakest growth in recent period; more importantly, per cent of GDP in the budget presented for 2008-
while industrial growth turned negative in the last 09 in February 2008 to 6.0 per cent in the interim
quarter, the deceleration in services persisted in budget presented in February 2009 before the
all successive quarters of the year. The sharp general elections and further to 6.2 per cent in the
moderation in GDP growth warranted appropriate provisional accounts for 2008-09. In addition,
fiscal and monetary policy response, which was special bonds amounting to 1.8 per cent of GDP
delivered swiftly, that too in a forward looking were issued to oil marketing companies and
manner in the second half of the year, in anticipation fertiliser companies during 2008-09 to cover for
of the adverse ramifications of the global crisis on their under-recover ies in the face of high
the domestic growth. The significant deceleration international prices and lower administered prices,
in private consumption demand and the slowdown which had become necessary to contain the
in investment demand, and the associated spiralling of inflation in the first half of the year.
contraction in output necessitated expansion in Besides the deterioration in the fiscal parameters

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 ANNUAL REPORT

of the Centre under the compelling needs of fiscal Bank and its policy response gradually turned to
stimulus, the fiscal deficits of the State modulating the monetar y overhang, without
Governments also witnessed some deterioration. restricting the growth in credit and money that was
The fiscal correction and consolidation process of necessary for sustaining the high growth. Reflecting
the State Governments that was progressing during the cautious monetary stance, the repo and reverse
the previous few years was halted during 2008-09, repo rates were raised gradually since September
although the consolidated revenue account of the 2004, along with higher reserve requirements. The
State Governments continued to remain in modest tightening stance had to be pursued more
surplus. Implementation of the Sixth Pay Commission aggressively in the first half of 2008-09 to contain
award by some of the State Governments did exert the building inflationary pressures. Reflecting the
pressures on the revenue expenditure of the States. moderation in growth in the second half and the
The consolidated gross fiscal deficit (GFD) of States contraction in aggregate demand, non-food bank
based on the revised estimates rose to 2.7 per cent credit, which was growing at 29.4 per cent in
of GDP from 2.1 per cent in the budget estimates October 2008 (year-on-year basis) fell to 17.5 per
on account of lower revenue surplus and non-debt cent by end-March 2009. Part of the high growth in
capital receipts coupled with higher capital outlay. credit up to October 2008 reflected the shift in the
The combined fiscal deficit (Centre and States), pattern of resource mobilisation by the corporates
including the special securities issued to oil in the face of emerging global credit squeeze. The
marketing and fertiliser companies, thus, reached external funding was partly substituted by resort to
10.7 per cent of GDP in 2008-09. domestic credit. Moreover, there was a sharp
increase in credit to oil marketing companies which
reflected the rising international oil prices and high
Financing of Fiscal Deficit
cost of impor ted crude. After October 2008,
I.11 The challenge associated with financing of however, with sharp fall in international oil prices,
higher deficits emerged in the form of managing the demand from oil companies came down at the
large borrowing programmes of the Governments same pace. Moreover, decline in commodity prices,
without disr upting the mar kets, and more need for clearing the inventories accumulated at
importantly, without exerting upward pressures on high cost in the face of falling demand and falling
the interest rates. Significant moderation in inflation prices, as well as weakening business confidence
in the second half of the year; the deceleration in contributed to the sharp drop in credit growth. Credit
demand for non-food credit, reflecting the slowdown extended by private and foreign banks exhibited
in growth; and the decline in non-bank sources of much sharper deceleration in growth in relation to
funding for the commercial sector created the the nationalised banks. More importantly, flow of
headroom for smoother management of the resources from non-banking avenues (such as from
borrowing programme. The net market borrowings the capital market, non-banking finance companies,
of the Centre and the States jumped to Rs.4,02,302 ECBs, FCCBs, ADRs/GDRs and FDI) also fell by
crore (7.5 per cent of GDP) in 2008-09 from about 20 per cent over the level in the previous year.
Rs.1,66,895 crore (3.5 per cent of GDP) in 2007- Relaxing all constraints on the expansion in credit
08; special securities outside the market borrowing at lower cost without dilution of the emphasis on
programme increased to Rs.95,942 crore in 2008- asset quality emerged as a major challenge for the
09 from Rs.38,050 crore in 2007-08. Reserve Bank. Many Central Banks around the
world had to confront with the challenge of
The Monetary Stance unfreezing the credit market; in India, however, the
credit mar ket functioned nor mally, and the
I.12 The high growth in credit and broad money deceleration in credit growth reflected slowdown in
in 2004-08 was taken cognisance of by the Reserve real activity. The Reserve Bank ensured ample

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 ASSESSMENT AND PROSPECTS

surplus liquidity in the system to ensure flow of credit but the timing of the unwinding could also be
to productive sectors, within the prudence necessary modulated in such a way that the large borrowing
for preserving the asset quality of the banks. programme of the Government was managed
smoothly without exerting any market stress. The
Liquidity Management reduction in CRR from 9 per cent to 5 per cent
represented release of large liquidity to the banking
I.13 The monetary aggregates – both broad system. The monetary operations of the Reserve
money and reserve money – evolved during the Bank, in the wake of addressing the impact of the
year reflecting the fast changing inflation and growth crisis, thus, were significantly different from the
outcomes, as well as swings in domestic and experience of many central banks of the advanced
international liquidity conditions. This was reflected economies, even though the ultimate objective was
in sharp shifts in the composition of monetary almost the same, which was to ensure adequate
aggregates on both sources and components sides. liquidity in the banking system.
In recent years up to the first half of 2008-09,
increase in net foreign assets of the Reserve Bank, I.14 The reduction in CRR by 4 percentage
reflecting the surges in capital flows, had become points released Rs.1,60,000 crore of liquidity to the
the dominant source for expansion of base money. banking system. While the first round immediate
In the third quar ter of 2008-09, however, the impact of a reduction in the CRR leads to
balance of payments came under pressure, and the corresponding fall in the reserve money, it implies
reserve drawdown that became necessary to higher money multiplier, which leads to higher
finance the deficit in capital inflows, led to increase in broad money. Since moderation in
corresponding contraction in base money. The reserve money growth was the result of a deliberate
Reser ve Bank had to more than offset the expansionary policy action, the Bank had to
contraction in reserve money by expanding its net emphasise the “adjusted reserve money” indicator
domestic assets (NDA) so as to ensure necessary to communicate the monetary developments to the
growth in money supply consistent with the needs public.
of economic growth, besides the provision of ample
liquidity to alleviate any fear of liquidity shortage in Monetary Transmission
the Indian markets. The Reserve Bank ensured
the necessar y expansion in NDA through I.15 Despite persisting with the expansionary
conventional open market operations (OMOs) monetary policy stance in the post-September
involving outr ight purchase of gover nment 2008 period, which was reflected in 400 basis
securities in the secondary market, as well as points reduction in CRR, 4.25 percentage point
provision of liquidity through acquisition of reduction in the repo rate, 2.75 percentage point
secur ities by repos under the LAF. Another reduction in reverse repo rate and several other
instrument which allowed the Reserve Bank to conventional as well as non-conventional windows
expand liquidity was the unwinding of the MSS for access to liquidity (resulting in the availability
secur ities. MSS secur ities had become an of more than Rs.4,00,000 crore of additional
impor tant instrument of sterilisation to par tly actual/potential liquidity to the system by the end
neutralise the expansionary effects of surges in of the year), the transmission of monetary policy
capital flows in the earlier years. While dealing with became a matter of concer n. The complete
the challenge of expanding the NDA to offset the transmission of monetary policy takes place with
impact of contracting NFA on reserve money, the long and variable lags. But in the midst of a sudden
unwinding of MSS balances not only created the reversal in risk perception, the risk premium could
scope for adequate liquidity expansion by the increase significantly to often more than offset the
Reserve Bank without expanding its balance sheet, magnitude of fall in the policy rates. As a result,

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 ANNUAL REPORT

the cost of funds may not decline for the customers, CPI inflation at the retail level continues to be high,
or may even increase, despite significant fall in the and inflation expectations also have not receded
policy rates. This was experienced in several at the same pace as the WPI inflation. In view of
advanced economies, where the yield spreads these reasons, monetary policy effectiveness
increased significantly at some stage, reflecting continues to remain a challenge, which though is a
heightened risk aversion. In India, while universal concern and not specific only to India.
reassessment of risk was one of the factors Since the last quarter of 2008-09, however, the
constraining the transmission of monetary policy, deposit and lending rates have started to moderate
there were several other structural factors in in response to the significant reduction in policy
operation as well. First, the administered interest rate rates and sustained ample liquidity in the system,
structure for small savings restricts flexibility on besides the Reserve Bank’s constant emphasis on
deposit rates for the banks, as small savings could better policy transmission in the credit market.
potentially compete with deposits depending on
the relative difference in the interest rates offered
Inflation Divergence
on both savings instruments. Second, depositors
often lock their deposits at the high interest rate I.16 Headline inflation, as measured by year-on-
for longer term during a high interest rate phase; year variations in the WPI, declined sharply to 0.84
as a result, banks face the constraint of reducing per cent by end March 2009 from the peak of 12.91
the cost of lending in a phase of economic per cent on August 02, 2008. The spurt in volatility
slowdown since their cost of funds remains high in WPI inflation needs to be seen in the context of
because of term deposits contracted earlier at the behaviour of global commodity prices during
higher rates. Till the term deposits become due for the year. Reflecting the sharp increase in oil and
maturity, at which stage the deposits could be metal prices in the global markets, WPI inflation
renewed at the lower rate, the banks experience had risen to double digits in June 2008 and
structural rigidity in their balance sheet. Third, remained elevated till October 2008. As the global
several concessional administered loans to sectors commodity prices moderated from their peak levels,
like agriculture and exports are linked to the BPLR, domestic prices also adjusted sharply thereafter.
which works as a disincentive to revise the BPLR Excluding the volatile fuel and metals components
downwards even in the face of falling policy
in WPI, however, the WPI inflation was less volatile,
interest rates and use of moral suasion by the
in the range of 10.2 per cent in August 2008 to 4.8
Reserve Bank to emphasise the need for lower
per cent in March 2009. The pass-through of global
lending rates as one of the means to support
commodity prices to domestic prices was
recovery in growth. Fourth, banks often compete
incomplete because of administered price
to mobilise bulk/wholesale deposits, and they have
mechanism and fiscal interventions for several
to prevent shifting of such deposits to other banks,
commodities, which helped in moderating the price
which creates the associated pressure to delay
pressures and containing the volatility in inflation.
the revision in interest rate to the extent possible.
The prices of food articles, however, continued to
In the conduct of its policies, the Reserve Bank,
rule high, as a result of which the consumer price
as a public institution, has to also remain sensitive
indices (CPIs) remained firm near double digit
to the interest of the depositors, given particularly
the role of high domestic savings in India in the levels, given the higher weight of food articles in
high growth phase of 2003-08 and the relatively CPIs. The Reserve Bank’s Annual Policy Statement
higher degree of insulation of Indian growth compared in April 2009 recognised the emerging significant
to most other countries during 2008-09. Despite divergences between inflation in WPI and CPIs and
significant moderation in WPI inflation to below 1 per emphasised that for policy purposes it continuously
cent by the end of 2008-09 and then to sub-zero level, monitors the full array of price indicators.

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 ASSESSMENT AND PROSPECTS

External Contagion and Financial Markets liquidity in the afternoon as against the normal LAF
access in the morning, special 14 days repo facility
I.17 In the post-September 2008 period, the
using SLR eligible securities up to 1.5 per cent of
major concern for the Reserve Bank was to deal
NDTL for meeting the liquidity needs of NBFCs,
with the knock-on effects of the global financial
housing finance companies and mutual funds,
crisis. With sharp increase in the overnight call rate
advance release of money at the request of the
in India to 13 per cent on September 16, 2008 and
Government to the banks towards Agricultural Debt
further to a peak of 19.8 per cent on October 10,
Waiver and Debt Relief Scheme, increase in export
2008, the volume under the LAF repo window of
credit refinance limit for commercial banks, and
the Reserve Bank (which is used on a day-to-day
special refinance facilities for specialised financial
basis by the banks for accessing liquidity) increased
institutions such as the SIDBI, NHB and EXIM Bank.
from around Rs.12,500 crore in the first half of
The additional liquidity that was made available
September 2008 to Rs.68,000 crore in the second
exceeded Rs.4,00,000 crore (by the end of the
half of the month, and further to Rs.90,000 crore in
year), which is unprecedented and amounted to 7.9
early October 2008. Demand for liquidity had
per cent of GDP.
increased from many quarters, that too suddenly.
Corporates had increased the demand for credit at I.19 For dealing with the excess demand
home as a substitute for external financing in the conditions in the foreign exchange market, given
face of global credit squeeze. Access to trade credit particularly the objective of containing excessive
was becoming difficult, and the cost also had gone large volatility, a number of measures were initiated
up. NBFCs and mutual funds, given the nature of to ease the supply situation by partly assuring
their sources of funds, also faced major liquidity greater access to the Reserve Bank’s foreign
shortage. In view of the capital outflows and the reserves and partly by improving the inflows in
pressures on the balance of payments in the third response to specific measures. Besides the actual
quarter of the year, the exchange rate came under intervention sales in the foreign exchange market,
pressure, which warranted intervention operations the Reserve Bank also opened the forex swap
by the Reserve Bank to restore orderly conditions facility for the banks. To ease the demand pressure
in the foreign exchange market. This, in turn, implied from oil importing companies during the high and
corresponding contraction in rupee liquidity in the rising phase of international prices, the Bank had
banking system. The Reserve Bank, thus, had to already started special market operations in the
ensure supply of adequate rupee as well as foreign secondary market through commercial banks
currency liquidity to restore the call money rate involving direct supply of forex liquidity against the
within the LAF corridor and also to contain volatility oil bonds of the public sector oil mar keting
in the exchange rate. companies. The policy measures that aimed at
improving the supply of forex liquidity included
permitting banks to borrow from their overseas
Reserve Bank’s Responses to the Contagion
branches within prudential limits, relaxing further
I.18 For enhancing the availability of domestic the external commercial borrowing policy, including
liquidity, besides the usual reduction in CRR, allowing NBFCs and housing finance companies
greater access under the LAF through repos, and to borrow in foreign currency, and raising the
unwinding of the MSS securities, several other interest rates on NRI deposits. Notwithstanding the
conventional as well as unconventional instruments demand pressure in the forex market, in view of
were also used depending on the nature and depressed inter national asset pr ices, the
expected magnitude of the demand for liquidity, corporates were permitted to prematurely buy back
such as a second LAF window providing access to their FCCBs at prevailing discounted rates.

9
 ANNUAL REPORT

I.20 Recognising the difficult challenges in the reverted to within the LAF corridor or around the
credit market, the Reserve Bank had to balance ceiling by the end of October 2008 and the LAF
the priorities of credit quality and improved credit window also moved from net injection to net
delivery. As counter cyclical regulatory measures, absorption mode, indicating the surplus liquidity
the Reserve Bank reduced to normal levels the conditions in the system since November 2008.
provisioning requirement for standard assets and Reflecting the measures taken for improving the
risk weights for certain asset classes, which had availability of forex liquidity, the average exchange
been increased earlier during the period of rapid rate of the rupee which had depreciated sharply
credit growth. With a view to further strengthening from Rs.40.02 per US dollar at the beginning of April
the domestic banking sector, the Reserve Bank also 2008 to Rs.51.23 per US dollar in March 2009, has
undertook a number of other regulatory initiatives, appreciated since then to around Rs.48.0 per US
which include: (i) review of prudential framework dollar in the first half of August 2009. The 10-year
for off balance sheet exposures of banks covering benchmark government securities yield also
issues like risk weights, provisioning and credit softened from the October 2008 levels by the end
conversion factors; (ii) strengthening of systems of the year, despite significant increase in market
for monitoring large un-hedged foreign exchange borrowings in the second half of the year. Thus,
exposure of corporates; (iii) enhancing cross border the transmission of the Reserve Bank’s policies
supervision and consolidated supervision of bank to the money, forex and the government securities
led conglomerates; (iv) reviewing supervisory markets has been effective, thereby ensuring
framework for monitoring the activities of Special speedy restoration of orderly conditions over a short
Purpose Vehicles(SPVs) and trusts set up by banks; time span.
(v) reviewing the appropriateness of the current
supervisory framework for monitoring the overseas The Resilient External Sector
operations of Indian banks; (vi) issuing guidelines
on managing maturity mismatch for addressing I.22 The exter nal sector of the economy
liquidity risks in the very short run; (vii) discouraging exhibited resilience despite significant pressures
the practice of excessive reliance on call money on the balance of payments through the trade and
borrowing by linking the borrowings to banks’ capital flows channels, particularly in the third
capital; and (viii) modifications to guidelines on quarter of the 2008-09, when the reserve loss
restructuring of advances. Despite the risk of (excluding valuation) was US$ 18 billion in just one
contagion from the global financial crisis, the Indian quarter. While net capital flows remained negative
banking system remained sound and resilient, as even in the fourth quarter of the year, the reserve
evident from the soundness indicators like capital loss was negligible because of surplus in the current
adequacy, asset quality and profitability for 2008-09. account. For the year as a whole, the current
While the capital adequacy level for the banking account deficit widened to 2.6 per cent of GDP in
system was at 13.2 per cent at the end of the year, 2008-09 from 1.5 per cent of GDP in 2007-08, with
each individual bank was above the minimum 9 per a total loss of reserves of US$ 20.1 billion (net of
cent capital adequacy requirement prescribed by valuation). Overall, there was substantial decline in
the Reserve Bank. Stress-testing findings of the net capital inflows from US$ 108 billion in 2007-08
Committee on Financial Sector Assessment to US$ 9.1 billion in 2008-09, with last two quarters
(CFSA) also suggested the resilience of the of the year showing net outflows. The financial
financial system and the adequacy of capital levels. channel of the contagion from the global financial
crisis, thus, was distinctly felt in the form of reversal
Impact of the Reserve Bank’s Actions in capital flows, which affected the domestic
financial markets, in particular, the stock market
I.21 Responding to the large and comprehensive and the forex mar ket. The significance of
domestic liquidity measures, the inter-bank call rate maintaining comfor table foreign exchange

10
 ASSESSMENT AND PROSPECTS

reserves, even with a largely flexible exchange rate in domestic aggregate demand on account of the
regime, thus, became evident during the year when apprehensions spilling over to the consumers and
one of the severest external shocks could be investors from the severe global recession emerged
managed without any exceptional measures to as the key challenge to sustained high growth. In
modulate the specific transactions in the current 2008-09, management of high inflation in the first
and capital accounts. half and preserving the soundness and resilience
of the financial system in the second half were the
Managing Macroeconomic Challenges key policy challenges. By the beginning of 2009-
10 the major policy concerns were slow recovery
I.23 The management of the macroeconomic in growth despite use of large fiscal stimulus and
environment during 2008-09, thus, was exceptionally accommodative monetary stance, global recession
challenging for the Reserve Bank, as the magnitude weakening the export prospects, less than expected
and pace of the external contagion had the potential correction in real estate prices constraining a
to cause severe disruptions to critical segments of recovery in housing demand, high food and
the economy. Preventing a liquidity scare, with consumer price inflation and the risk of inflationary
ample provision of liquidity, both domestic and pressures firming up further due to the impact of
foreign currency, was the immediate challenge in sustained recovery-focused fiscal-monetary policy
the post September 2008 period, and both money stance, implications of protracted growth slowdown
market and forex market returned to normal for asset quality of banks, and the increasing
conditions within two months in response to possibility of large borrowing programmes limiting
Reserve Bank’s actions. With a sound banking the options for monetary policy by potentially
system, the liquidity of non-banks like NBFCs, mutual exerting upward pressures on market interest rates
funds and housing finance companies were also met and competing with the credit demand from the
to avoid the failure of any financial institution on private sector, and thereby constraining the return
account of lack of access to liquidity. In the wake of to the high growth path in the medium-term.
net capital outflows and difficult conditions for
access to international markets, while assuring the
PROSPECTS FOR 2009-10
market to provide the needed liquidity from the
comfortable foreign exchange reserves, steps were The Uncertain Global Outlook
taken to make certain inflows more attractive. Given
I.25 The external economic environment is
the overriding impor tance of containing the
unlikely to remain congenial for supporting a faster
moderation in flow of credit to the private sector for
recovery in India, because despite improved
sustaining the growth momentum, counter cyclical
financial market conditions and thaw in the pace of
prudential regulations were used to encourage
contraction in global activity, the recession in
banks to lend. The policy rates were also brought
advanced countries is widely perceived to persist
down significantly so as to lower the cost of funds
in 2009. The IMF’s outlook released in July 2009
and thereby spur consumption and investment
suggests that global growth would contract by 1.4
demand. The fiscal stimulus, that involved significant
per cent in 2009, and the volume of world trade
increase in the government borrowing programme,
would also decline by 12.1 per cent. The recovery
posed the challenge of smooth completion of the
is widely perceived to be gradual, and even with
borrowings without disrupting the markets.
the upward revision to the IMF’s growth outlook for
I.24 Notwithstanding the Reser ve Bank’s 2010 at 2.5 per cent, that would represent just about
actions that prevented the financial system from half of the growth achieved in 2007. Moreover,
stress and thereby avoided any risk to the growth despite diminishing uncertainty and improving
process from the financial system, the slowdown confidence as well as receding financial stress,

11
 ANNUAL REPORT

bank lending conditions remain tight, housing represent the overarching priorities of the
markets are yet to bottom out, and banks’ balance Government, and the macroeconomic policy
sheets need to be cleansed further. In the second environment has to respond to this broad overall
quarter of 2009, while the rate of contraction in the objective. As external demand operates as a major
US and Euro-area GDP slowed down significantly, drag on the recovery, growth impulses have to
Japan, Hong Kong, Germany and France recovered depend even more on domestic demand than in
from the recession, and China and Korea exhibited the past and public expenditure has to take the lead
acceleration in growth. Emerging signs of in boosting aggregate demand in the face of
improvement in the global macro-financial deceleration in private consumption demand and
conditions, however, need to gain roots for ensuring investment demand. This realisation is reflected in
a sustained global recovery. According to the the increase in government expenditure by 33.1 per
Global Development Finance of the World Bank cent in 2008-09 and by 13.3 per cent over the high
June 2009, the industrial production in rich base of the previous year, as budgeted for 2009-10.
countries has declined by 15 percent since August
2008, and that in developing countries (excluding I.27 The relatively higher resilience of Indian
China) the decline has been by 10 percent. The growth to the global economic crisis was on
external financing conditions for the developing account of the dominant role of domestic demand
countries has been viewed to remain difficult in and domestic saving. The increase in savings rate
2009, with private capital flows expected to decline from 23.5 per cent in 2001-02 to 37.7 per cent in
from US$ 707 billion in 2008 to US$ 363 billion in 2007-08 largely allowed a sustainable investment
2009. The IIF’s June 2009 projections for capital driven high average growth of 8.8 per cent over
flows to EMEs suggest that net flows could fall 2003-08, besides the congenial productivity
sharply to about US$ 141 billion in 2009 from US enhancing influence of reforms. In the process of
$392 billion in 2008. According to the July 2009 reverting to the high growth path, same level of
estimates of the World Bank, remittance flows to support from domestic saving may be required,
developing countries could decline to US$ 304 which, however, may be difficult in the immediate
billion in 2009 from US$ 328 billion in 2008, run due to the operation of two factors, which would
suggesting that the impact on remittance receiving have dampened the performance on the saving
countries may not be as strong as the trade and front. Public sector savings, which had been
capital flows channels. Rising unemployment, showing signs of improvement in recent years
however, entails the risk of tighter immigration reflecting the disciplining influence of the FRBM,
policies. The assessments of international agencies is expected to register some deterioration due to
indicate that trade, capital flows and remittances higher fiscal deficits as the outcome of using
may take some time to revive to normal levels and appropriate fiscal stimulus to contain the slowdown
contribute to growth. If the protectionist response in growth, besides the expected subdued
of some countries continues, global recovery may performance of the public sector enterprises in a
not immediately lead to corresponding revival in phase of economic slowdown. Depressed
world trade. Moreover, rebalancing of the global corporate earnings associated with deceleration in
growth to correct the accumulated global aggregate demand could also lead to some erosion
imbalances of the past years may also affect the in savings of the private sector. The growth in
growth prospects of many countries. overall domestic savings, thus, could be expected
to decline modestly in 2009-10. This, however, may
not operate as a constraint to growth in the short-
Return to the High Growth Trajectory
run, since in relation to the aggregate demand
I.26 Reverting to the high growth path at the adequate liquidity is available in the banking
earliest and ensuring an inclusive growth process system. Moreover, during the phase of economic

12
 ASSESSMENT AND PROSPECTS

slowdown, corporates could have undertaken could benefit the rural households directly, besides
efficiency enhancing restructuring of the the income enhancing/supporting policies
production processes, which otherwise might have associated with the increase in MSPs and food
been difficult to implement in the preceding phase subsidies.
of high growth. This could help in strengthening
the growth momentum once the recovery sets in. Agricultural and Allied Activities
Inventory levels, which would have declined during
the slowdown, may also support a faster revival I.29 The agricultural growth prospects in 2009-10
when aggregate demand recovers. In the medium- have to be assessed taking into account the output
run, as the fiscal stimulus is withdrawn gradually impact of deficient monsoon. With almost 60 per
and the fiscal policy stance reverts to the path of cent of the agricultural land being rain-fed, Indian
consolidation and discipline, return to the same agriculture is still dependent on the performance
level of domestic savings that could be consistent of the monsoon, par ticularly the South-West
with the sustainable growth level of 9 per cent monsoon. Dur ing the last ten years, large
would be feasible. cumulative deficiency in rainfall was observed
during 2002 (-19 per cent) and 2004 (-13 per cent).
On both these occasions, there was an adverse
Aggregate Demand
impact on foodgrains production. While agricultural
I.28 The composition of aggregate demand had production had contracted by 7.2 per cent in 2002,
to tilt in favour of government demand, on account the production level in 2004 had held up at the same
of the use of fiscal stimulus to contain the growth level as in the previous year due to the robust growth
slowdown. In view of the payments made under the in allied activities. The past experience, thus,
Far mer Debt Waiver Scheme, Sixth Pay suggests that the spatial and temporal distribution
Commission and fiscal stimulus measures, the of the rainfall is critical in influencing the overall
share of government final consumption increased outcome for agriculture. According to the August
to over 11.1 per cent of GDP in 2008-09 from 9.8 2009 revised monsoon rainfall projections of the
per cent of GDP in the previous year. The revival in India Meteorological Department (IMD), the rainfall
private consumption demand, however, is essential deficiency in 2009 (during June-September) could
to not only stimulate investment demand but also be about 13 per cent. The actual position up to the
to facilitate faster fiscal consolidation. In this second week of August 2009 shows that the
context, promoting r ural demand assumes cumulative shortage of rainfall is about 29 per cent
significance not only in view of the higher share of in relation to the nor mal levels. Moreover,
r ural consumption in aggregate pr ivate production weighted rainfall index of the Reserve
consumption but also because of greater Bank shows a shortfall of 36 per cent, which is
vulnerability of rural consumption in an environment higher than what is indicated by the cumulative
of deficient monsoon as well as high food articles rainfall pattern. Crop sowing position as on August
inflation, both of which could erode rural disposable 13, 2009 indicates that sowing of most pulses and
income. The share of rural consumption in total coarse cereals are higher than last year’s levels,
household consumption has remained consistently though paddy sowing has been substantially lower,
in the range of 55 per cent to 60 per cent in last i.e. about 19 per cent below last year’s level. Given
one decade, and is expected to grow at a faster the fact that kharif paddy contributes about 86 per
pace with rising inter-linkages and catching up with cent of total rice production and 36 per cent of total
the urban life style. Recognising the importance of foodgrains production in India, foodgrains
rural demand in moderating the impact of the production in 2009-10 could be adversely affected
slowdown, the Union Budget for 2009-10 increased because of the deficiency in rainfall. According to
outlays under several schemes significantly that the Food and Agriculture Organization (FAO),

13
 ANNUAL REPORT

India’s paddy output in 2009-10 may decline by public investment on expanding the irrigation
2.5 per cent. Rainfall deficiency entails the potential, improving the market structure for
additional r isk of shor tfall in hydro power agricultural commodities ensuring competitive
generation, which may also add to the existing pricing, hedging options for management of crop
infrastructure constraint to growth, particularly when uncertainty, adequate warehouse facilities and
the energy demand increases with the recovery. improved rural roads enhancing better connectivity
with urban markets also must receive greater policy
I.30 The rainfall deficiency during the kharif
attention. Better water management with an
season, thus, could affect the growth and inflation
emphasis on water harvesting would be important
outlook, besides rural disposable income. Rural
for moderating the impact of below normal monsoon
demand that had remained buoyant so far on
on farm output.
account of record food grains production last year,
may also experience some moderation, which in
Industrial Sector
turn could influence the recovery prospects of
certain industries that benefited earlier from the I.31 Despite positive growth and signs of
robust rural demand. FMCG sector could be recovery in the first quarter of 2009-10, the growth
particularly affected, and the stock markets have outlook for the industrial sector remains mixed. The
already responded to the monsoon related outlook pace of industrial output in a number of emerging
for different sectors as well as the overall economy. and industrial economies had declined by double
Notwithstanding the macroeconomic concerns digit levels during the second half of 2008-09. In
associated with the rainfall deficiency, one needs India also, the IIP registered a growth of 2.7 per
to recognise the progress on effective diversification cent in 2008-09, which is the lowest since 1992-
of Indian agriculture towards horticulture, livestock 93, with negative growth in one month of the year.
and fisheries, and their rising shares in the total The unregistered manufactur ing sector has
output of the agricultural sector. Horticulture, generally moved in line with the registered
livestock and fisheries contribute close to 60 per manufacturing sector, and the performance could
cent of the GDP originating from “agriculture and be expected to have been equally subdued than
allied activities”, and “cereals, pulses and oilseeds” the organised sector as micro and small enterprises
grown during kharif account for only 20 per cent of (MSEs) often depend on large enterprises through
the total agricultural output. As in the previous year, forward and backward linkages. The concern
improved Rabi performance may also help in relating to flow of credit to the SMEs also needs to
moderating the output effects of monsoon during be addressed. In view of the prevailing
the kharif, which though would depend on the uncertainties, the Reserve Bank has set up an
rainfall pattern in the remaining phase of the South Industry Monitoring Group drawing members from
West monsoon as well as precipitation during North external agencies as well as from concerned
East monsoon. While the record foodgrains depar tments of the Bank in Apr il 2009 to
production in 2008-09 and comfortable buffer periodically assess the developments in Industry
stocks of rice and wheat have enhanced the in relation to changes taking place in the global
capacity to deal with price pressures in 2009-10 economy and the financial sector.
on account of the deficient rainfall, enhancing the
agricultural output, driven by higher yield and I.32 The manufacturing sector’s performance
diversification of crops, assumes importance. in a competitive environment and in the face of risks
Higher investment backed by sustained research of rising protectionism could encounter several
and extension activities could be critical for challenges. Despite the advantages of a large
augmenting yield. Besides the policy focus on using domestic market, abundant availability of skilled
higher MSP to generate supply response and labour force, and the proximity to the fast growing

14
 ASSESSMENT AND PROSPECTS

Asian markets, productivity growth needs to catch East-Asian crisis in 1997 and the technology
up with the Asian economies, including China. This meltdown in 2000. The current global economic
requires greater emphasis on quality, better crisis being unprecedented in the recent history in
adoption of technology, more flexible labour laws, terms of the magnitude of the impact as well its
significantly improved infrastructure and a policy duration, the past resilience of the services sector
environment supportive of the SMEs sector. The could be tested in 2009-10. Unlike the impact on
industry-education linkages must be strengthened manufacturing that started in the second half of
vigorously. The technological breakthrough for 2008-09, the impact on services may be felt with a
product development, including patent protection, lag, since the use of services as input to output
has often acted as a deterrent to attract sizeable growth in organised manufacturing has been rising
investment into R&D in many industries, notably in the past. The services sector competition also
the drugs and pharmaceuticals. Persistent thrives on labour productivity as well as intensity,
problems like delayed payments after delivery, which is important in the context of the demography
frequent disruptions in the availability of power, and of India in favour of the young population as well
lack of stable demand also affect the performance as the need to absorb the surplus labour available
of the manufacturing sector. The strong inter- currently in the agriculture sector. The direct
linkage with the performance of the export sector contribution of global factors to the services output
has been a factor in affecting the industrial growth has been rising since 2001, with increasing global
in the face of contracting external demand. integration in services trade under the multilateral
framewor k, favourable ter ms-of-trade and
communication revolution providing strong fillip to
Services Sector
both on and off-shore outsourcing of business
I.33 The underlying impetus of high growth in processes, activities and knowledge. The
India has been the sustained robust performance protectionist tendencies in some of the countries
of the services sector. This sector has not only affected by the ongoing economic crisis have
exhibited minimum growth of 9 per cent in the recent created concerns for the prospects of external
five years, but its share in aggregate GDP has also demand for Indian services , but India’s comparative
increased to about 64.5 per cent. The significant advantage continues to be strong.
progress made by the services sector has been
I.35 Notwithstanding the high growth and
partly possible because of the strong growth in
resilience of the services sector in the recent past,
services exports. The contribution of services
the sector faces multiple challenges for sustained
exports in overall value added accelerated sharply
growth over the years. A number of services where
from 6.9 per cent in 2000-01 to 21.6 per cent during
India enjoys comparative advantages experience
2008-09. Indian services sector has competitive
lack of clear policy thrust. For instance, despite the
edge in several knowledge based ser vices
high quality of healthcare services, it attracts a
segments viz., software, business processing and
number of regulations. Similarly, in education,
healthcare, while in the remaining areas, India may
multiple regulation points and lack of credible
have to gain the competitive edge; the availability
accreditation systems hamper the growth potential.
of modern physical infrastructure along with quality
Given the medium to long-term contribution of
human resources would be important to spur the
investments on education and health to growth and
growth impulses in the services sector.
productivity, availability of these ser vices at
I.34 Histor ically, the ser vices sector has affordable cost while enhancing their global
consistently showed resilience since 1990-91, and competitiveness must form part of the priority in
remained largely unaffected by the past instances India’s development process. A number of services
of external crises such as the Gulf crisis in 1991, in India are either predominantly associated with

15
 ANNUAL REPORT

the Government or not liberalised enough to ensure per cent (for CPI-AL), 11.3 per cent (for CPI-RL),
growth through organised private initiatives. 9.6 per cent (for CPI-UNME) and 9.3 per cent (for
Ser vices like professional, legal, postal, CPI-IW). The significant divergent behaviour of the
accountancy and insurance need fur ther inflation is largely on account of the differences in
liberalisation to harness their potential. the coverage of items and their weights in the WPI
and CPI. At the disaggregated level, even within
Growth Outlook the WPI, inflation in food articles and essential
commodities remain close to the inflation as per
I.36 The Reserve Bank’s survey of professional
different indices of CPI. The divergent inflation
forecasters conducted in June 2009 indicated an
pattern as per the WPI and CPI indices has
upward revision in the median growth outlook to
increased the complexity in the assessment of
6.5 per cent from the earlier outlook of 5.7 per cent
inflation, and for policy purposes, the Reserve Bank
as per the previous Survey conducted in March
monitors the full array of price indicators. Moreover,
2009. Currently available projections of growth for
inflation expectations have not declined as much
India in 2009-10 generated by various international
as the fall in WPI inflation and expansionary fiscal
and domestic organisations suggest a range of 4.8
stance with an accommodative monetary policy
per cent to 7.5 per cent. Taking into account the
may not lead to sobering of inflation expectations,
global developments as well as the developments
even if the headline inflation remains negative for
in domestic aggregate demand and the recent
few months.
output outlook for the three broad constituent
components of GDP (i.e. agriculture, industry and I.38 The steady increase in the WPI over its end-
services), the first quarterly review of the monetary March 2009 level indicates the persisting upward
policy for 2009-10 conducted on July 28, 2009 momentum in inflation, and trends in global
placed GDP growth for 2009-10 at “6.0 per cent commodity prices in the first quarter of 2009-10
with an upward bias”. Since the presentation of the suggest that upside risks to inflation could persist
policy statement, while the extent of rainfall from rebound in global commodity prices ahead of
deficiency associated with the South West monsoon global recovery. Increase in Minimum Support Price
has increased, the IIP figures for June 2009 (MSP), that may be seen as a measure to support
released in August 2009 show significant recovery the farmers in a below normal monsoon year could
in Industrial output. stoke inflation. More importantly, the deficient
monsoon could affect the inflation outlook more
Inflation Outlook than the growth prospects. The first quarter review
of monetary policy conducted in July 2009 revised
I.37 In 2008-09, India witnessed large volatility
the inflation projection for the end of the year to 5
in headline inflation, which exceeded 12 per cent
per cent from 4 per cent projected in April 2009,
at one point and then fell to below 1 per cent by the
recognising the imminent signs of inflationary
end of the year. Since June 2009, year-on-year WPI
pressures, while highlighting the medium-term
inflation has remained negative, primarily reflecting
objective of 3.0 per cent inflation.
the high base effect of the previous year that
resulted from significant increases in the prices of I.39 The divergent trends in inflation as
food and international commodities in the first half measured by the WPI and CPIs have warranted a
of 2008-09. The base effect could be expected to closer relook at the measurement issues as well
fade gradually and then disappear by October 2009, as the choice of an appropriate price index for
after which the positive WPI inflation will become monitoring changes in price levels at the national
visible. While WPI inflation has turned negative, level that could be used as the reference indicator
other indicators of inflation based on CPI for June for conduct of policies. In the absence of a
2009 (point-to-point) continue to remain high at 11.5 nationwide single inflation indicator based on

16
 ASSESSMENT AND PROSPECTS

consumer prices covering the entire population, that NRI deposits, FII portfolio inflows and inward
the wholesale price index (WPI) has been used FDI flows have generally been strong, as against
as the headline inflation indicator as it is more the net capital outflows witnessed in the last two
representative and provides information on prices quar ters of 2008-09. The liberalised external
on a weekly basis with the minimum lag. The payments regime has been facilitating the process
current WPI series (with base year 1993-94) does of acquisition of foreign companies by Indian
not completely capture the nature of transactions corporates, both in the manufacturing and services
in the economy, as considerable str uctural sectors, with the objectives of reaping economies
changes have occurred in the economy since then. of scale, improving access to technological
In this context, the Government’s decision to revise knowhow and increasing strategic presence in
the base year to 2004-05 is expected to improve offshore markets to face the global competition.
the representativeness of WPI, as more number Besides the lower current account deficit,
of products, including from the unorganised sector, reasonable debt sustainability indicators and
is proposed to be covered in the new series, along comfor table foreign exchange reserves would
with reassigning of weights. The ongoing efforts ensure external stability, notwithstanding the
for compiling nationwide consumer price indices persistent adverse global economic conditions.
for both rural and urban areas by the Central
Statistical Organisation (CSO), as per the I.41 The strong export growth of India in recent
recommendation of the National Statistical years before the global recession started has been
Commission, would also improve the information driven by the productivity changes underway in
base on price movements. the Indian industry. The import intensity of exports,
however, has also been steadily rising as domestic
entities have expanded access to internationally
The External Sector Outlook
available raw materials and intermediate goods
I.40 The outlook for the exter nal sector as well as quality inputs for providing the
suggests that despite persistence of the global competitive edge to domestic production and
recession in 2009, the external sector is unlikely to enhance export capabilities. The prospects for
cause concern for growth and stability in India. The recovery in exports have to be seen in the context
latest available trends for 2009-10 indicate that of low external demand due to the global recession
current account deficit as percentage of GDP would and the resultant pressure on export prices and
be lower than that in 2008-09. Both exports and margins, protectionist measures adopted by
imports continued to decline in the first quarter of several countries, significant stimulus given by
2009-10, but the decline in imports has been India’s competitor countries to their exporters, and
sharper than the decline in exports, resulting in a uncertainty faced by exporters about timely receipt
narrowing down of trade deficit. However, global of payments. For improving the prospects for
oil prices have increased in recent months, which, exports on a more sustainable basis the emphasis
if sustained, may put some pressure on the trade should be on diversification, in terms of both
and current account deficits. The relative stability markets and export items, and competitiveness,
in the software ser vices expor ts and inward without making the sector to remain dependent
workers’ remittances, as witnessed in the previous on incentives like tax breaks, lower excise and
year, could impart resilience to the current account customs duties on inputs used for exports, and
in 2009-10. Even though net capital flows to EMEs concessional interest rates on financing for
are expected to decline during 2009, capital flows exporters, even though such incentives may be
to India may increase because of better medium- necessary in a phase of contraction in global
term growth and faster recovery prospects. Early demand as a temporary support to the export sector.
indications for the first quarter of 2009-10 suggest Incentive dependent exports could hamper the

17
 ANNUAL REPORT

progress on productivity as the durable means to I.44 The quality of fiscal consolidation has to
higher exports. South–South trade may also have to be given priority attention in view of the fact that
be recognised for its potential in augmenting exports even the post FRBM improvements in key deficit
growth in future. indicators were possible primarily on account of the
revenue buoyancy. On account of the FRBM Act,
I.42 The experience relating to surges in capital
revenue deficit and fiscal deficit came down from
flows for successive years, followed by sharp
2.5 per cent and 4.0 per cent of GDP in 2004-05 to
reversals in the second half of 2008-09 highlight
1.1 per cent and 2.7 per cent of GDP, respectively,
the importance of management of capital flows,
in 2007-08. These improvements in fiscal indicators
given their ramifications for the exchange rate and
were largely revenue led. The revenue buoyancy
the conduct of monetar y policy, and more
improved significantly as a result of higher
importantly, for the overall macroeconomic and
economic growth during this period and also due
financial stability. A diversified capital account, with
to deliberate policy action towards improvement in
a hierarchical preference for FDI over debt flows,
tax administration through computer ised
and for long-term flows over short-term flows,
information system and institution of tax information
should be the focus of external sector policy. Fuller
network (TIN). The revenue receipts to GDP ratio
capital account liberalisation remains a medium-
increased from 9.7 per cent in 2004-05 to 11.5 per
ter m objective, recognising the growing
cent in 2007-08, which accordingly contributed to
ineffectiveness of micro controls in a world of
reduction in fiscal deficit to GDP ratio by 1.8
growing trade and financial integration.
percentage points. On the other hand, contribution
from compression in aggregate expenditure to
Fiscal Consolidation
reduction in fiscal deficit at 0.7 percentage points
I.43 The fiscal stance of the Government in the of GDP was much smaller. Decline in non-debt
face of deteriorating global conditions and weakening capital receipts ( i.e . recover y of loans and
domestic growth impulses was guided by the need disinvestment proceeds) by 1.2 per cent of GDP,
for preventing a sharp contraction in growth in both however, led to partial offsetting of the positive
2008-09 and 2009-10, while recognising the need impact of revenue buoyancy and expenditure
to revert to the path of fiscal consolidation as soon compression on fiscal deficit. Not only that
as possible. The fiscal consolidation during 2003-04 expenditure compression had the lowest
to 2007-08, driven by revenue buoyancy during the contribution to fiscal consolidation, but even the
high growth phase, had created some fiscal space composition of increase in expenditure tilted against
to activate discretionary counter-cyclical fiscal policy. capital expenditure. While the revenue expenditure
The Union Budget for 2009-10 envisages further to GDP ratio increased by 0.4 percentage points,
deceleration in revenue collection due to the that of capital expenditure declined by 1.1
economic slowdown, as also partly due to tax cuts percentage points, reflecting lack of focus on
that were undertaken earlier to support growth. The expenditure management in contributing to the
expenditure, in turn, was increased to support quality of fiscal consolidation.
aggregate demand by enhancing allocation for the
crucial sectors such as infrastructure in rural and I.45 While the fiscal measures undertaken to
urban areas, education and health, rural employment revive growth have led to deviation in fiscal targets
programmes and schemes for the weaker sections. envisaged under the FRBM Act during 2008-09 and
On the taxation front, the changes in both direct and 2009-10, the Government has committed to return
indirect taxes have been envisaged to address the to FRBM mandate in the next two years. Though
concerns of growth and equity. The gross tax-GDP the stance of long-term fiscal policy beyond 2010-
ratio is budgeted to decline to 10.9 per cent during 11 would emerge later this year when the Thirteenth
2009-10 from a peak of 12.6 per cent in 2007-08. Finance Commission presents its report, there are

18
 ASSESSMENT AND PROSPECTS

several factors which could enable the Government important part of the initiatives on expenditure led
in returning to the FRBM path. Expenditure on fiscal consolidation.
account of payment of Sixth Pay Commission
arrears and farm loan waivers would be paid out I.47 On the revenue front, introduction of goods
by 2009-10. Frontloading of the plan expenditure and services tax (GST) is an important policy
approved for the Eleventh Five Year Plan as fiscal reform. The GST would facilitate greater vertical
stimulus measures would also imply lower plan equity in fiscal federalism and reduce the cascading
expenditure in the remaining years. As tax nature of commodity taxes, since the base for
collections, particularly direct taxes are cyclical in assessment would be the value addition. In the
nature, revenue buoyancy is expected to rise again Union Budget for 2009-10 it has been indicated that
with the pickup in growth momentum. The the broad contour of the GST model would be dual
Government could also reverse the indirect tax cuts GST, comprising Central GST and State GST. The
with the revival of the economy. Goods and services Centre and States will legislate, levy and administer
tax (GST) proposed to be introduced from April the Central GST and State GST, respectively. The
2010 could also be expected to improve the revenue Central Government has reiterated its commitment
buoyancy. In this regard, the Government has also to facilitate the introduction of GST by April 1, 2010,
recognised the importance of institutional reform after consultations with all stake holders. The share
measures encompassing all aspects of budget such of services sector in total tax revenue is not
as subsidies, taxes, expenditure and disinvestment. commensurate with its share in GDP, although the
ser vices tax collections have witnessed an
I.46 The fiscal consolidation path may have to impressive growth during the period 2003-04 to
involve considerable and careful rationalisation of 2008-09, from 0.3 per cent of GDP in 2003-04 to
expenditure. The capital outlay to GDP ratio has 1.2 per cent and budgeted at 1.1 per cent of GDP
been around 1.5 percent for last several years. in 2009-10. Within gross tax revenue, the share of
Capital outlay, which is budgeted at 1.7 per cent of services has increased from 3.1 per cent in 2003-
GDP during 2009-10 would need to be stepped up 04 to 10.4 per cent in 2008-09 and budgeted at
significantly over time. Non-plan expenditure would 10.1 per cent for 2009-10. With the introduction of
have to be checked. During 2009-10, non-plan GST, more number of services would also be
revenue expenditure consisting mainly of interest brought into the tax net and consequently tax
payments, defence expenditure, subsidies, wages contribution from the services sector could be
and pensions and grants to States appropriated expected to increase substantially.
over 60 per cent of the total expenditure (about 10
per cent of GDP). In the near future interest I.48 The fiscal consolidation process entails the
payments, which represent a major non- risk of affecting social sector spending as much as
discretionary component of expenditure, could infrastructure spending. The expenditure incurred
appropriate over one-third of total revenue receipts. on education and health in recent years as per cent
This underpins the need for fiscal consolidation. to GDP showed marginal improvement from 0.4
The quality of fiscal consolidation, based on per cent and 0.2 per cent in 2003-04 to 0.6 per
successful international experience, suggests that cent and 0.3 per cent, respectively, in 2008-09.
it should be driven by expenditure rationalisation/ These are budgeted at 0.7 per cent and 0.4 per
compression. A ceiling on the share of non-plan cent for 2009-10. Compared to other emerging
expenditure in total expenditure may be integrated market economies, expenditure on health and
into a medium-term plan for enhancing the quality education is low in India. Given the already low level
of fiscal consolidation. Moreover, improving the of expenditure on these crucial sectors, as a
productivity of public expenditure and quality of the minimum, there is a need to maintain the gradual
public service should also be emphasised as an upward momentum witnessed in recent years. The

19
 ANNUAL REPORT

process of fiscal consolidation, therefore, should interest payments on these securities will impinge
not be achieved at the cost of cut backs in on the revenue deficit of the Government. The Union
expenditure towards these sectors. Budget for 2009-10 has lowered the provisions for
fertiliser subsidy in 2009-10 by 34 per cent over
Disinvestment the revised estimates for 2008-09, assuming that
the prevailing lower prices of fertilisers will continue
I.49 In the context of options for faster return to in the international markets. Food subsidies have
the fiscal consolidation path, mobilisation of been raised by 20 per cent in order to ensure food
resources through disinvestment has been security for BPL families. Together with the provision
highlighted in some quarters. The experience with for special securities to oil marketing companies,
disinvestment programme in recent years indicate the total provision for major subsidies is budgeted
that proceeds from disinvestment were the highest to be around 2 per cent of GDP for 2009-10, as
in 2003-04, amounting to Rs.16,953 crore, and no against 4.2 per cent of GDP in 2008-09. Moreover,
subsequent momentum has been achieved since expenditure by the States on subsidies has been
then. With the setting up of National Investment Fund at around 0.4 to 0.5 per cent of GDP in recent years.
(NIF), all the proceeds from disinvestment of Central This order of subsidy of the Centre and States taken
Public Sector Enterprises (CPSEs) are required to together is high for a country where budgetary
be routed to it, which is maintained outside the resources have competing demands and which
Consolidated Fund of India. The Fund is managed have stronger potential for contributing to growth
professionally to provide sustainable returns to the and development. Without explicit mandated
Government, that too without any depletion of the provisions to cap expenditure on subsidies, needs
corpus. Only the annual income of the Fund can be for greater public investment in infrastructure, both
spent, with 75 per cent for financing select social physical and social, could be sacrificed as an
sector schemes in the field of education, health and outcome associated with higher subsidies.
employment and the balance 25 per cent for meeting
the capital investment requirements of profitable and I.51 As regards fertiliser subsidies, the move
revivable CPSEs. There is a need to step up towards nutr ient based subsidy regime as
disinvestment for greater resources mobilisation. announced in the Union Budget 2009-10 could
ensure balanced application at reasonable prices.
Furthermore, the move towards a system of direct
Subsidies
transfer of subsidy to the farmers in due course
I.50 Management of subsidy has posed a will ease the pressure on fertiliser subsidies as
persistent policy challenge. The high fertiliser prices leakages could be reduced. Over time, fertiliser
prevailing in global commodity markets during the prices need to be decontrolled. As irrigation is a
first half of 2008-09 and the enhanced minimum critical factor determining the use of fertilisers, and
support price for wheat and rice led to sharp has a significant impact on foodgrain production,
increases in fertiliser and food subsidies in 2008-09 public investment in irrigation could be a more
(RE) by Rs.44,863 crore and Rs.10,960 crore, efficient policy instrument rather than subsidy.
respectively, over the budget estimates. Apart from
these subsidies, which are explicitly provided for in
Infrastructure
the Budget, implicit subsidies provided for by way
of issue of special securities to oil and fertiliser I.52 India’s high growth trajectory has exerted
companies amounted to Rs.75,849 crore and significant pressures on the available physical
Rs.20,000 crore, respectively, in 2008-09 so as to infrastructure, and infrastructure deficit is widely
compensate for under recoveries. This has added recognised as a major constraint to attracting
to the subsidy burden of the Government, as the foreign investment and promoting efficiency in

20
 ASSESSMENT AND PROSPECTS

production in India. The Eleventh Five Year Plan crore) in infrastructure; financing this level of
envisages stepping up of the gross capital formation investment, however, remains a challenge ahead.
in infrastructure from 5 per cent of GDP in 2006-07 Several new initiatives have been initiated in the
to 9 per cent of GDP by end of the Plan period in recent years focussing particularly on the rural
2011-12, and this could be critical to achieve the 9 infrastructure development. To stimulate public
per cent growth. The large financing requirement investment in infrastructure, a special purpose
that is necessary to almost double the investment vehicle - India Infrastructure Finance Company
in infrastructure has to be also seen in the context Limited (IIFCL) was set up for providing long-term
of challenges for investment in both public and financial assistance to infrastructure projects. The
private sectors. Public investment continues to Union Budget for 2009-10 announced that IIFCL
dominate the infrastructure sector in India and when would, in consultation with banks, evolve a ‘take
the Government is expected to go through an exit out financing’ scheme (which would address asset
phase to revert to the fiscal consolidation path, liability mismatch of commercial banks arising out
accelerating the pace of public expenditure for of infrastructure financing) to facilitate incremental
infrastructure could become difficult. In attracting lending to the infrastructure sector. In recent years,
private investment to infrastructure projects, the some progress is discernible in attracting private
challenge is to make the investment attractive investment in infrastructure sectors such as
enough in terms of expected return on capital while telecommunications, power generation, airports,
also being fair to the consumers and actual users ports, roads and the railways through public private
of the infrastructure. Moreover, besides the current partnerships (PPPs).
focus on growth, improving the quality of life through
I.54 PPPs have grown in popularity around the
provision of moder n physical and social
world with governments otherwise finding it difficult
infrastr ucture should also be given greater
to finance infrastructure investments through
importance. During the implementation stage of the
conventional revenue raising mechanisms like
projects, more rigorous mechanism must be put in
taxation or borrowings. In financing large-scale PPP
place to enhance the quality of the infrastructure.
programmes, there could be the constraint in terms
Development of infrastructure is the key to a
of mobilisation of long-term funds. PPPs in India
sustainable high and inclusive growth process and
rely on commercial banks for funding, which by
is necessary for connecting producers to markets,
nature cannot be for very long-period. Bank
lowering transaction costs and also providing a
financing for PPP projects exposes the banks to
larger section of the population access to services
risk concentration, besides refinancing uncertainty
like communication, education, and healthcare.
at maturity, and the risk of changing interest rates
India’s rapid industr ialisation and growing
and credit conditions over time. An active bond
urbanisation continue to put pressure on
market could diversify risks, besides elongating the
infrastructure demand; as infrastructure projects
duration of finance. The financing challenges
are capital intensive with long gestation period, the
suggest the need for greater Government support,
return is uncertain and low in risk adjusted terms,
ranging from direct equity contribution to use of
which warrants provision of special preferential
government guarantees and extension of tax
incentives in the policy framework for generating
breaks. To ease the financing constraints for
the desired supply response.
infrastructure projects under the PPP mode, the
I.53 Addressing the growing infrastructure gap Gover nment has decided that IIFCL would
would be critical for both sustaining higher growth refinance 60 per cent of commercial bank loans for
as well as improving the quality of life. The Eleventh PPP projects in critical areas over the next fifteen
Five Year Plan has estimated an investment to eighteen months. The IIFCL was authorised to
requirement of US$ 502.88 billion (Rs.20, 11,521 raise Rs.10,000 crore through Gover nment

21
 ANNUAL REPORT

guaranteed tax free bonds by the end of 2008-09 adaptation skills. They are creative and are driven by
and an additional Rs.30,000 crore on the same the animal spirit of making profits. They are also risk
basis as per the requirement in 2009-10. The takers. Hence, a special Government funded scheme
refinancing option is expected to leverage bank for providing necessary opportunities to existing and
financing for PPP programmes to the extent of potential entrepreneurs could be appropriate.
about Rs.1,00,000 crore.
Food and Energy Security
Technology and Innovations
I.56 The global developments on the food and
I.55 For sustaining the high growth, there has energy fronts in 2008 highlighted the importance
to be significant emphasis on raising the of food and energy security for ensuring sustainable
productivity levels, for which innovations and and inclusive high growth in India. Insulating the
adoption of technology would be critical. Any common man from the vulnerability associated with
contribution to growth that emanates from factors high food price inflation warrants a more robust food
other than labour and capital is generally seen as security system in India, which could allow high
the contribution of technology in growth accounting, growth in agriculture without depressing the prices
which is broadly captured under “total factor too much while also preventing escalation in food
productivity (TFP)”. International as well as prices in the eventuality of production shortfalls. The
domestic empirical evidences recognise the role extent of volatility that was witnessed in
of technological progress in economic growth international food prices in 2008-09, and the
through increase in TFP. Factors ranging from specific measures that the Government of India had
education, rule of law, openness to trade and capital to undertake in terms of banning export of certain
flows and institutional reforms could contribute to items and reducing the prices of certain imported
technological progress, besides innovations and items through lower tariffs, also highlight that India
adoption of new technology. For enhancing may have to put in place a more comprehensive
productivity, thus, expenditure on primary health, food management system that is consistent with
education, vocational training and R & D may be high growth and low inflation objectives while also
raised, besides facilitating larger flow of credit. ensuring adequate supply of food articles at the
Entrepreneurship needs to be incentivised for lowest possible prices to the vulnerable sections
promotion of innovation and growth of old and new of the society. This is particularly relevant on
businesses. Enhanced credit availability to business account of the fact that a large segment of the
start-ups is one of the measures to facilitate the Indian population has no access to any assured
growth of entrepreneurship. Start-ups are expected social safety fall back options. The current buffer
to have a higher failure rate, which may have to be stock policy may have to be better aligned to the
recognised in the regulatory norms relating to asset goal of stabilising food price inflation while
quality. Innovations in areas in which India has simultaneously promoting higher growth in
gained expertise and competitive edge (e.g. ICT, agricultural output, so that despite the costs
pharmaceuticals and biotechnology) also need to involved, surplus production could be absorbed in
be encouraged. FDI often brings with it modern years of good agricultural production to avoid any
technology and other practices which contribute to sharp fall in prices, while also releasing adequate
productivity; there is, therefore, a need for a more stocks from the available buffer stock during periods
liberal FDI policies. In view of the low yield in Indian of shortfall in domestic production in relation to
agriculture, productivity enhancing technologies are demand. Other growth enhancing measures could
particularly required for more inclusive high growth include higher public investment in agriculture,
and rural development. Entrepreneurs are generally better crop balancing, research and extension
innovators and known for their development and services, and prevention of degradation in soil

22
 ASSESSMENT AND PROSPECTS

productivity while enhancing the sustainability of the world. The May 2009 ILO Update on Global
available ground water for agricultural use. The Employment Trends projects additional
emphasis should be also on diversification of unemployment of over 50 million (in the worst case
agriculture, from rain-fed to dry land farming, from scenario) as a fallout of the global economic crisis
food crops to non-food cash crops, and from in 2009. While no information is available at the
dependence on agriculture as the sole source of macro-level in India on the unemployment scenario
living to non-farm rural employment. Climate arising from the slowdown in growth, unemployment
change related issues will assume greater very much remains a concern, and there are
prominence over time, and could potentially disturb evidences of some increase in unemployment in
the rainfall pattern in future; there could be gradual certain sectors. The Ministry of Labour in India had
international consensus over time on emission conducted two quick quarterly surveys for the
limits for countries, which in turn would require period October-December 2008 and January-
larger public investment on clean technology. March 2009 in select business segments to assess
the impact of the global contagion and domestic
I.57 Besides food security, energy security is
slowdown on employment. The survey found a
another challenge, and the behaviour of energy
decline in overall employment growth in industries
prices in 2008-09 only highlights the urgency that
like textiles, metals, automobiles, gems and
should be assigned to this issue. Significant
jewellery, transport and IT/BPO by 1.0 per cent (or
dependence on imports for ensuring assured
0.5 million job losses) during the third quarter of
supply of POL products in the domestic market
2008-09, with the gems and jewellery and transport
warrants adequate strategic policies to contain any
segments showing (-8.6 per cent) and (-4.0 per cent)
potential risk to future growth path arising from
change in employment. While export oriented units
possible emergence of sudden deficits in energy
exhibited pressure on employment, non-exporting
availability. Incentives to private investment and
units experienced modest employment growth.
higher public investment on exploration and
production of crude and natural gas would be I.59 The employment situation in the fourth
necessary. Any fiscal measures to moderate the quarter of 2008-09, however, improved, even in
impact of high oil prices over a sustained period certain export-oriented segments, particularly
could drag the fiscal position to unsustainable textiles, IT/BPO, automobiles, gems and jewellery
levels. Decontrol of prices for all POL products by
and handloom/powerloom; the employment
linking the pricing directly to international prices,
situation though deteriorated in other export
and delivering subsidies explicitly as a cash outgo
oriented sectors like leather, metals and transport,
affecting the budget deficit contemporaneously,
where employment remained below the September
instead of through oil bonds, could be the first step
2008 levels. The Reserve Bank’s Industrial Outlook
towards promoting energy security. The next
Survey conducted in April-May 2009 showed that
important steps could involve provision of sufficient
as per expectations about employment in July-
fiscal incentives for promoting energy conservation
September 2009, there would be net hiring in the
and efficient use, for attracting private investment
manufacturing sector.
in generation and conservation of power, and more
importantly, research and extension activities on I.60 The Government has undertaken several
non-conventional clean energy. measures to promote growth in the sectors facing
Employment slowdown, and thereby prevent increase in
unemployment. Prominent among these are
I.58 The employment effects of the global establishment of two new mega clusters for
economic recession have been a key driving factor handlooms and carpets, interest subvention on pre-
behind the use of large stimulus packages all over shipment credit for labour intensive export oriented

23
 ANNUAL REPORT

sectors, enhanced ECGC cover, and reduction in period of seven years. While sanctioning projects
basic customs duty and service tax exemption to utilising the additional central assistance under the
select exports. Enhanced resource allocation in JNNURM, priority has been given to projects such
2009-10 for national flagship schemes such as as water supply, sanitation and storm water
National Rural Employment Guarantee Scheme drainage, which benefit the common man and the
(NREGS) (rise by144 per cent), Bharat Nirman (rise urban poor. This process needs to be further
by 45 per cent), National Highway Development strengthened.
Programme (rise by 23 per cent), Jawaharlal Nehru
Urban Renewal Mission (JNNURM) (rise by 87 per Financial Sector Reforms
cent) could help in generating additional
employment, particularly in the un-organised I.62 While India’s financial sector remained
sector, both in rural and urban areas during 2009- resilient in the face of global shocks, there are a
10. There have been reports of reverse migration number of areas where the reforms would be
– from urban industrial clusters to the rural areas needed to promote stability and generate growth
within India – and the protectionist response of impulses for the real economy. An important
several countries in terms of tighter immigration challenge is to channelise more savings to the
policies on account of their own deteriorating financial system, particularly in rural areas and from
employment conditions. the urban informal sector. This would need further
penetration of the banking system. The Reserve
Bank’s emphasis on financial inclusion is important
Urbanisation
in attaining this objective over time. There is also
I.61 Approximately 30 per cent of India’s enormous potential for expanding financial services
population resides in urban areas currently. The in semi-urban and rural areas for productive
proportion of people living in urban areas is going activities, which may require strengthening the
to increase at a faster pace in the next thirty years banking correspondent relationship, simultaneously
on account of organic growth as well as the enhancing the r isk assessment and r isk
continued rural-urban migration. Considering the management capacities in order to maintain credit
important role that urbanisation has played in quality and sustain the credit growth in the informal
economic development more recently in South-East sector. Further reduction in the cost of banking
Asia and China, the role of proper urban planning services may require greater competition among
and management cannot be overemphasised. product lines, improved delivery mechanisms and
Focus is required not just on hard infrastructure increasing use of information technology. With a
such as water, sanitation, sewerage, urban view to ensuring that domestic savings could
transportation, power and communication, but also finance long-term investment in projects having
on softer areas such as education (primary, long gestation lags, the insurance and pension
secondary, higher and vocational) and health. sectors, would be critical, due to the very nature
Traditionally, provision of public goods and services of their liabilities, as well as a vibrant bond market.
is financed by tax flows and public borrowings while This may, however, require a number of reforms in
that of private goods and services is financed the insurance sector such as increasing flexibility
through user charges. In India, the importance of for the insurance companies to raise capital and
user charges in developing and sustaining the bring in greater competition and enhance depth in
urban infrastructure is well recognised. The the insurance and pension funds markets. Deep
Jawahar lal Nehr u Urban Renewal Mission and liquid domestic mar kets with var ied
(JNNURM), launched in 2005-06, is by far the most participation can absorb overall risk better and
ambitious programme aimed at improving the civic reduce the excessive volatility that often adds
service levels in identified mission cities over a uncertainty to the investment climate. From this

24
 ASSESSMENT AND PROSPECTS

perspective, the corporate bond market in India has amplitude of the business cycle and the real costs
lagged behind in comparison with other financial of an external or financial sector shock could be
market segments, owing to many structural factors. disproportionately high. In the sphere of regulatory
Rationalising the primary issuance procedure, and supervisory architecture, alongside the current
facilitating exchange trading, increasing the emphasis on the soundness of individual banks and
disclosure and transparency standards and institutions as a means to ensure systemic stability,
strengthening the clear ing and settlement increasing emphasis has to be laid on macro-
mechanisms in the secondar y mar ket are prudential regulation that could promote and
necessary in this regard. Cross-border banking, in strengthen systemic stability.
the post crisis period, has to be examined with
I.64 In India, elements of macro-prudential
greater caution, and future reforms in this area must
regulation were visible even before the global crisis
be guided by progress on adequate mechanisms
started, in terms of counter-cyclical use of risk-
and systems to prevent the possibility of sudden
weights and provisioning norms. Macro-prudential
and large external contagion creating systemic risks
analysis could provide the early warnings for
for the domestic financial system. For sustaining
timely identification of systemic risks, while macro-
the high growth path, improving the investment
prudential regulation could prevent the emergence
climate and enhancing the absorptive capacity
of systemic risk in the financial system. In view of
would be critical. In this context, financial sector
the interconnectedness between banks and
reforms have to emphasise promoting financial
institutions, financial markets, and the economy,
inclusion, ensuring wide and deep financial markets
systemic risk analysis would involve interpreting
and facilitating the growth of strong, competitive and
the changing dynamics between these three
sound financial institutions.
segments on a continuous basis. Any vulnerability
in any small segment of these broad areas could
Financial Stability Architecture amplify and become systemic in view of the strong
I.63 The post-cr isis revamping of the inter-linkages.
architecture for promoting financial stability as a I.65 The international initiatives that could lead
precondition to growth could encompass the process for strengthening the global financial
macroeconomic policy issues as well as financial systems would involve significant coordination
regulation and super vision. In the sphere of among national regulators, besides revamping of
monetar y policy, alongside the predominant national stability frameworks reflecting the global
emphasis on inflation, asset price bubbles driven trends and country specific requirements. The
by credit boom and excessive use of leverage has ongoing inter national initiatives indicate a
to receive greater attention, notwithstanding the multipronged approach, covering several important
current lack of clarity on how does monetary policy aspects of stability: (a) introducing automatic
respond to asset prices? The fiscal policy stance stabilisers into the regulator y framework by
has to recognise the limits of pro-cyclical fiscal adopting counter-cyclical capital charge, so that
stance, and the importance of adequate fiscal adequate cushion could be built up during the
consolidation and sustainability as a necessary booming phase of the business cycle which could
stimulus to high growth and stability. In the Indian be used to deal with the asset quality problems that
context, inherent rigidities that constrain faster may arise during the waning phase of the business
consolidation has to be taken into account; cycle; (b) adequacy and quality of capital as per
adequate fiscal space has to be built up as a Basel-II r isk based capital framewor k, and
cushion over time to deal with future shocks to the simultaneous use of simpler measures such as the
growth process. Leverage driven or export/capital leverage ratio ; (c) capital requirements for
flows dependent growth could increase the reputational and other r isks in respect of

25
 ANNUAL REPORT

securitisation activities and activities undertaken financial stability framework, supporting pillars have
by the sponsored or connected conduits/shadow been laid out through special exercises like
banks; (d) capital treatment for trading book periodical reviews of the banking sector, micro
exposures, and the need for supplementing value- prudential reviews, interest rate sensitivity analysis,
at-risk approach with incremental risk charge so and vulnerability assessment. Tools such as stress
as to minimise the incentive for regulatory arbitrage testing and scenario analysis are also used,
between banking books and trading books, (e) depending on the evolving financial/economic
strengthened Pillar 2 supervision, focusing on risk environment in the country. The counter cyclical
concentration, off-balance sheet exposures, approach to supervision, that is being highlighted
valuations of financial instruments, access to internationally as a post-crisis reaction to revamp
funding liquidly during hypothetical possibility of a the architecture for financial stability, where the
financial crisis, stress test practices adopted in prudential requirements like build up of capital and
banks and system level stress-tests and their / or provisions is enhanced during the good times,
integration into capital and liquidity planning; and to meet the stress on the asset quality during
(f) promotion of market discipline under Pillar 3 financial downturns has been implemented in India
through better disclosure and clarity on the risk even before the onset of the crisis.
associated with exposure to certain instruments. The
I.67 The macro-pr udential dimension of
international deliberations have also highlighted
systemic risk assessment has become particularly
other important issues like the risk associated with
important in the context of the current global
distorted incentive structures for the market players,
financial crisis. Since r isk assessment is a
the inadequacy of self regulation for rating agencies,
continuous process and stress tests need to be
the deficiencies of models for risk analysis and
conducted taking into account the macroeconomic
measurement, and the need for improving market
linkages as also the second round effects and
structure for derivatives. The emerging international
contagion risks, consequent to the announcement
standards and best practices would have to be
in the Annual Monetary Policy Statement of 2009-
carefully examined from the stand point of their
10, an inter-disciplinary Financial Stability Unit has
relevance to India, while further strengthening the
been set up to monitor and address systemic
domestic financial stability framework to avoid
vulnerabilities. In addition to applying stress tests
systemic stress on the financial system.
to the portfolios of individual institutions at the micro
I.66 As on March 31, 2009, all Indian banks, level, stress-testing in macro-prudential analysis is
including the foreign banks, have migrated to the becoming more relevant for systemic risk analysis.
Basel II standardised approaches, and hence, they The main objective of an economy and financial
will be subject to the Supervisory Review and system level stress test is to help public authorities
Evaluation Process (SREP) under Pillar 2 of Basel identify those structural vulnerabilities and overall
II for assessing the capital requirement as also the risk exposures that could potential lead to systemic
capital adequacy of each bank vis-a-vis its risk problems. The principles enunciated by BCBS on
profile and the standard of its internal controls stress testing as per its final guidelines issued in
system and r isk management practices. May 2009 emphasize the importance of macro level
Consolidated supervision mechanism for the forward looking stress testing for assessing the
banking group with bank as parent entity has been adequacy of capital and liquidity. The Reserve Bank
put in place. Financial Conglomerate Monitoring is in the process of revising guidelines on stress
Mechanism already is in vogue since June 2004 in testing and liquidity risk management taking into
India. Steps are being taken to strengthen Cross account the new guidance issued by BCBS. It is
Border Supervisory Co-operation. With a view to also considering to lay down a risk management
strengthening and formalising a comprehensive and capital adequacy framewor k for bank

26
 ASSESSMENT AND PROSPECTS

sponsored private pools of capital (e.g. private growth can only increase inflation in future.
equity funds / venture capital funds), especially in Secondly, large borrowing programmes and high
view of the reputational r isk ar ising from fiscal deficits complicate the challenge even further
undertaking such activities. by accentuating inflationary expectations, which
could worsen the actual inflation situation over time
I.68 There is a perception that the impact of the
while also putting upward pressure on interest rates.
growth slowdown experienced in the second half
Subdued growth with high inflation erodes the
of 2008-09 could be seen in the form of pressures
disposable income of the masses, and as a result,
on banks’ asset quality during 2009-10, particularly
the recovery becomes even more difficult because
if the recovery gets delayed. Restructuring of
of sustained depression in aggregate demand. Low
accounts permitted by the Reserve Bank in 2008-
inflation is an essential precondition to spur private
09 has also been highlighted as a factor that
demand, and monetary accommodation of the large
temporarily delayed the emergence of asset quality
fiscal stimulus could support recovery in growth only
problems. It may have to be recognised that the
in a low inflation environment. Thirdly, for any early
objective of restructuring is to take a swift action
signs of recovery to gain momentum, private sector
based on detection of the weaknesses in viable
credit must grow. Better monetary policy transmission
entities which may be facing temporary cash flow
that could enhance the demand for credit is a key
problems due to internal or external factors, so as
challenge, notwithstanding the usual dynamics of any
to preserve their economic and productive value.
credit market which may not respond to monetary
The exceptional regulatory treatment was not
policy actions. Finally, with the return of capital inflows
extended ear lier to commercial real estate
to the pre-crisis period and revival in demand for
exposures as well as to capital market exposures
credit from the private sector, the costs of any delay
and personal/ consumer loans in view of the
in withdrawal of monetary accommodation and fiscal
possibility of fuelling asset price bubbles. The
consolidation could increase.
restructuring of accounts allowed up to June 30,
2009 aim at preserving economic value of units and I.70 The emerging inflation outlook and the
not ever-greening of problem accounts. Banks, medium-ter m consequences of sustained
therefore, have to use their judgement before accommodative monetary stance for inflation
agreeing to restructure, so as to ensure that suggest that timing and pace of exit from the current
restructuring is undertaken only for viable units. accommodative monetary policy stance would be
a major challenge for the Reserve Bank. If the
stimulus is sustained longer, the imbalances left in
POLICY CHALLENGES
the system could create market induced pressures,
I.69 The macroeconomic conditions in 2009-10 besides engendering the inflation situation, which
so far, and the expected outlook for growth and may work against the recovery. The exit options for
inflation suggest that there are clear policy fiscal policy have to be seen in the context of the
challenges for the Reserve Bank as well as for the fact that economic recovery in itself could allow the
economy as a whole. A major challenge for the automatic stabilisers to operate, by raising the
Reserve Bank is to deal with the unpleasant revenues, and creating scope for reduction in public
combination of subdued growth with emerging risk expenditure. What would be more impor tant,
of high inflation, which poses a complex dilemma however, is the discretionary unwinding measures
on the appropriate stance of monetary policy. In to ensure reverting to the fiscal consolidation path
such conditions, while withdrawal of monetary as an essential requirement for returning to the high
accommodation entails the risk of weakening growth path. This cannot happen through
recovery impulses, sustained accommodation and expenditure compression alone, because of
the associated protracted phase of high money associated growth implications; hence part of the

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 ANNUAL REPORT

adjustment has to come through revenue buoyancy, regulations and credit policy measures. For
higher tax base and better compliance. For the promoting financial stability, the new international
monetary policy, which has to be primarily guided initiatives in response to the global financial crisis
by the assessment of the likely path of the business have to be monitored and examined, with an
cycle and the inflation cycle, balancing the goals emphasis on country specific relevance, and the
of supporting growth and containing emerging future approach to financial sector reforms may have
inflationary pressures could become increasingly to be based on lessons from the recent crisis.
challenging over 2009-10, in the face of an
I.73 For the economy as a whole, the most
expansionary fiscal stance.
critical challenge is to revert to the high growth path,
I.71 For the Reserve Bank, thus, besides the which would be possible only with a faster recovery.
near term challenges of emerging inflationary The longer the growth impulses remain dampened,
pressures, management of large borrowing the fiscal policy will exhaust any available fiscal
programmes and the associated potential conflict space, and the costs of large fiscal stimulus will
between monetary and fiscal policy, there are other also increase with time. Secondly, deficient
medium-term issues associated with globalisation monsoon and the possible adverse effects on
as well international initiatives on revamping the agricultural output may not only put pressure on
architecture for promoting financial stability. While food prices but also increase the demand for more
openness offers a number of benefits, it increases subsidies and relief measures. The pressure on the
the risks from external demand and capital flows. fiscal situation could only increase if drought related
Swings in capital flows and sudden stops can have policy response involves further expansion in
a significant impact on exchange rates, domestic government expenditure, and the additional costs
monetary and liquidity conditions and overall associated with possible impor t of essential
macroeconomic and financial stability. Global commodities to improve domestic supply
growth and monetary conditions, therefore, have conditions. Given the fact that food prices remain
an influence on domestic policies. high, despite low overall WPI inflation, and that all
I.72 The single mandate linked to inflation CPI indices exhibit little moderation in inflation, the
objective has often been highlighted as a necessity supply side of food management would assume
for ensuring a better inflation environment, but critical significance for the Government. Thirdly, the
given the importance of other objectives for a unemployment effects of a long phase of economic
country of India’s size and diverse needs, the slowdown, with weakly developed social security
operational relevance of an inflation-centric system, suggest that the Gover nment’s
mandate has to be examined carefully. Supply preparedness for dealing with situations as in 2008-
driven large volatility in WPI inflation that was 09 should be strengthened, which must include
witnessed in 2008-09 could erode credibility of any counter-cyclical fiscal stance allowing build up of
inflation-centric monetary policy. Moreover, the significant cushion during periods of high growth.
WPI inflation has been quite different from the CPI But despite the FRBM, fiscal consolidation process
based inflation in India in the recent period, and remained slow. More impor tantly, the public
as a result which measure of inflation may be the expenditure was also not reoriented to address
most appropriate reference for conduct of monetary constraints to high growth, such as physical and
policy has also been an issue. The Reserve Bank social infrastructure.
operates with multiple objectives of price stability,
growth and financial stability. In the pursuit of I.74 The macroeconomic outlook for 2009-10,
multiple goals, the available instruments are used in terms of expected gradual recovery in growth
optimally with a mix of interest rate changes, and the emergence of inflation pressures by the
quantitative liquidity adjustment, prudential end of the year pose difficult challenge for the

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 ASSESSMENT AND PROSPECTS

conduct of policy, in terms of balancing the two key macroeconomic policies. In a globalised world,
objectives. While the fiscal stance has clearly tilted consumers’ and investors’ perceptions could often
towards the growth objective, the associated be influenced by global developments, and hence,
accommodative monetar y policy stance, if strengthened multilateral surveillance and effective
sustained longer, entails the risk of higher inflation, global action to prevent the emergence of major
which in itself may become a constraint to higher global imbalances would have to be ensured so as
growth in the medium-run. In India, globalisation to allow national policies the space for pursuing
certainly had the associated benefits, directly in and achieving the high and sustainable growth
terms of exports and capital inflows, and indirectly objectives. Overall, Indian growth continues to be
in terms of global perceptions of India as a major driven by domestic demand and domestic saving,
emerging economic power. The manner in which with foreign capital supplementing within the
Indian policies could manage the contagion from prudent approach to sustainable current account
the global crisis would have only further improved deficit. Thus, return to 9 percent growth trajectory
the global perception of India. The global crisis, would largely be determined by the country’s
when it started to spread, did not differentiate structural fundamentals and the responsive macro
countries on the basis of soundness of their policy environment.

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