Assessment of Macroeconomic and Monetary Developments during the First Half of  2005-06

Domestic Developments

1. The onset of theSouth-West monsoon was delayed this year by a week, but it picked up byend-June. As per the India Meteorological Department (IMD), excess or normalrainfall was observed in 32 of the 36 meteorological subdivisions and, for thecountry as a whole, rainfall during June-September this year was 99 per cent ofits long period average. By current assessment of area coverage under variouscrops, it is likely that the kharif output may register an increase over theprevious year’s level. In addition, the improvement in water storage levelsover the previous year augurs well for the outlook on Rabi production.

2.Prospects forsustained growth in industrial output have improved in an environment of risinginvestment and export demand, strong corporate profitability and buoyantbusiness confidence. The index of industrial production (IIP) increased by 8.8per cent during April-August 2005 as compared with the increase of 8.0 per centin the corresponding period of the previous year. There are signs of sustainedgrowth in the production of basic goods, capital goods and consumer goods.Despite some deceleration, export growth at 20.5 per cent in US dollar termsduring April-September, 2005 has remained robust, as against 30.8 per cent in thecorresponding period of the previous year.

3. In consonancewith the sustained growth of industry, there is a surge in non-food creditgrowth. Exports of manufactured goods and services remain buoyant and theinternational business environment and investor confidence in India continue toremain positive. Domestic production and imports of capital goods have risenstrongly in tandem, indicative of ongoing capacity expansion. With continuedbusiness expansion and lower interest costs, corporate profitability is highand there is an expansion in internal resources available for investment. Thesefactors have found reflection in upbeat sentiments and a brightened investmentclimate. The assessment of the corporate sector as reflected in the ReserveBank’s Industrial Outlook Survey presents an optimistic picture and theexpectations regarding the overall business situation for the October-December2005 quarter have improved further. The performance indicators for output,exports, working capital finance requirements and capacity utilization areexpected to be well above their levels a year ago. Other business expectationsurveys also exhibited similar improvements in outlook.

4. According to theCentral Statistical Organization (CSO), real GDP increased by 8.1 per centduring the first quarter of 2005-06 as against 7.6 per cent in the firstquarter of the previous year. The elevated level of international crude pricesimparts downside risks to overall GDP growth. At the same time, the robustindustrial and service sector growth and buoyant exports are likely to havesome positive impact on growth.

5. Scheduledcommercial banks’ credit increased by 14.2 per cent (Rs.1, 55,712 crore) up toSeptember 30, 2005, which was higher than the increase of 11.7 per cent
(Rs.98, 210 crore) in the corresponding period of last year. Food creditdeclined by Rs.1, 571 crore – as against an increase of Rs.2, 677 crore in theprevious year – reflecting lower procurement of food grains during the currentfinancial year. On the other hand, non-food credit posted an increase of 14.8per cent (Rs.1, 57,284 crore) as compared with an increase of 11.9 per cent(Rs.95, 533 crore) in the corresponding period of the previous year. While theoutstanding credit-deposit ratio increased to 65.8 per cent from 58.4 per centa year ago, the incremental non-food credit-deposit ratio declined to 75.2 percent as compared with 92.9 per cent.

6.on the basis,non-food credit growth at 31.5 per cent, net of conversion, as on September 30,2005 was higher as compared with 24.9 per cent a year ago. Non-food credit haswitnessed a structural shift towards the non-agriculture non-industrial sectorsin recent years. Credit off-take during the current financial year (up toAugust 2005) has, however, been broad-based. Credit to industry increased by 21per cent whereas credit off-take by agriculture and non-agriculturenon-industrial sectors increased by over 35 per cent each. The growth in creditto non-agriculture non-industrial sector is led by housing, real estate andpersonal loans. Within the industrial sector, significant increase in creditoff-take has been recorded by petroleum, coal products, power, roads and ports,cotton textiles, drugs and pharmaceuticals, gems and jewellery, iron and steel,other metal and metal products, automobiles and engineering.

7. Scheduledcommercial banks’ investments in bonds/debentures/shares of public sectorundertakings and private corporate sector, commercial paper (CP), etc.,declined by 11.7 per cent (Rs.11, 043 crore) during the current year so far (upto September 30, 2005) as compared with a decline of 3.9 per cent (Rs.3, 463crore) in the corresponding period last year. Scheduled commercial banks’investments in instruments issued by financial institutions (FIs) and mutualfunds also declined by Rs.3, 835 crore as against a decline of Rs.2, 864 crorein the previous year. With the significant expansion in non-food credit demand,the total flow of resources from scheduled commercial banks to the commercialsector increased by 12.7 per cent (Rs.1, 46,241 crore) as compared with theincrease of 10.3 per cent (Rs.92, 070 crore) in the corresponding period of theprevious year. The year-on-year growth in resource flow was also higher at 27.8per cent, net of conversion, as against 21.4 per cent a year ago.

8. Money supply (M3)increased by 9.6 per cent (Rs.2, 15,394 crore) in the current financial year upto September 30, 2005 as compared with 5.4 per cent (Rs.1, 08,791 crore) in thecorresponding period of the previous year. On an annual basis, growth in M3 at16.6 per cent, net of conversion, was higher than 14.6 per cent in the previousyear. Aggregate deposits of scheduled commercial banks rose by 12.3 per cent(Rs.2, 09,015 crore) as compared with an increase of 6.8 per cent (Rs.1, 02,885crore) in the corresponding period of the previous year. On an annual basis,the growth in aggregate deposits at 18.6 per cent, net of conversion, washigher than that of 15.8 per cent a year ago.

9. Reserve moneyincreased by 5.8 per cent (Rs.28, 557 crore) in the current financial year upto October 14, 2005 as compared with the increase of 0.6 per cent (Rs.2, 660crore) in the corresponding period of the previous year. While currency incirculation increased by 6.1 per cent (Rs.22, 516 crore) as compared with 4.3per cent (Rs.14, 039 crore), bankers’ deposits with RBI increased by 6.5 percent (Rs.7, 431 crore) as against a decline of 12.4 per cent (Rs.12, 930crore). As regards the sources of reserve money, net RBI credit to the Central Governmentincreased by Rs.11, 897 crore as against a decline of Rs.21, 395 crore.Adjusted for transactions under the liquidity adjustment facility (LAF), netRBI credit to the Central Government showed a lower increase of Rs.1, 822crore. The Reserve Bank’s net foreign exchange assets (NFEA) increased byRs.24, 272 crore as against a higher increase of Rs.58, 342 crore during thecorresponding period of the previous year. NFEA adjusted for revaluation,however, increased by Rs.30, 585 crore as compared with an increase of Rs.31,737 crore during the corresponding period of the previous year. The RBI’scredit to banks and the commercial sector continued to decline because ofreduced reliance on the standing facilities on account of comfortable liquidityconditions. The year-on-year increase in reserve money was 17.9 per cent as onOctober 14, 2005 as compared with 18.0 per cent a year ago. The balances underthe market stabilization scheme (MSS) which were Rs.64,211 crore as on March31, 2005 increased to Rs.68,276 crore by October 14, 2005. The ratio of NFEA tocurrency declined marginally from 166.2 per cent in March to 162.9 per cent(145.4 per cent, adjusted for MSS) by October 14, 2005.

10. Inflation, asmeasured by variations in the wholesale price index (WPI), on a point-to-pointbasis, receded from 6.0 per cent in April 2005 to 4.6 per cent by October 8,2005 despite upward adjustments in the administered prices of petrol, dieseland electricity and increase in the prices of aviation turbine fuel, naphtha,furnace oil and iron and steel. On an average basis, annual inflation based onthe WPI was 5.3 per cent as on October 8, 2005 as compared with 6.2 per cent ayear ago.

11. At adisaggregated level, the prices of primary articles (weight: 22.0 per cent inthe WPI basket) increased by 2.5 per cent as compared with an increase of 3.8per cent in the previous year. The fall in prices of primary articles wasmainly under non-food articles – raw cotton, oilseeds and sugarcane – andminerals, particularly iron ore. Prices of manufactured products (weight: 63.7per cent) increased by 2.6 per cent as compared with 7.2 per cent a year ago.In the category of manufactured products, declines in the prices of edibleoils, oil cakes, cotton textiles and manmade fibres softened the effects ofsharp increases in the prices of basic metals, alloys and metal products(particularly, iron and steel), chemicals and chemical products and machineryand machine tools.

12. The annualincrease in prices of the ‘fuel, power, light and lubricants’ group (weight:14.2 per cent) at 12.0 per cent (as on October 8, 2005) was higher than10.7 per cent a year ago. Excluding the fuel group, however, inflation on anannual basis at 2.1 per cent was significantly lower than headline inflation.During 2005-06 so far, oil prices in the international markets have continuedto remain high and volatile with the latest spike occurring at the end ofAugust on account of Hurricane Katrina in the US. The average price of a basketof major international crude varieties (Brent, WTI and Dubai Fateh) at aroundUS $60 per barrel during July-October 2005 was 18.4 per cent higher than inApril-June 2005 and 42.6 per cent higher than its level a year ago. Domesticprices of petrol and diesel were revised upwards in June and again in September2005. With the latest hike in prices effective September 6, 2005 the averagedomestic price of petrol and diesel (in the four metropolitan cities) hasincreased by 13.6 per cent over the end-March 2005 level and 22.0 per cent overthe level a year ago.

13. The full effectsof the pass-through of the increase in international oil prices have so farbeen dulled and the underlying inflationary pressures have been contained.Crude prices continue to remain the most critical factor in the outlook ondomestic inflation. In the remaining part of the year, inflation conditionswill warrant continuous vigil in view of the heightened uncertaintiessurrounding international crude prices and the eventual pressures for fullerpass-through into domestic inflation.

14. Inflation, asmeasured by variations in the consumer price index (CPI) for industrial workerson a point-to-point basis, was 3.5 per cent in August 2005 as against 4.6 percent a year ago. On an annual average basis, inflation as reflected in the CPI,was 4.1 per cent in August 2005 as against 3.4 per cent a year ago.

15. The marketborrowing programme of the Central Government has so far remained consistentwith the projections set out in the Union Budget for 2005-06 which placed thenet and gross market borrowings of the Central Government at Rs.1,10,291 crore and Rs.1, 78,467 crore, respectively. By October 21, 2005 theCentral Government had completed net market borrowings of Rs.59, 831 crore(54.3 per cent of the budgeted amount) and gross market borrowings of  Rs.1, 08,506 crore (60.8 per cent of thebudgeted amount). The Central Government’s borrowing programme broadlyproceeded in alignment with the indicative issuance calendar for datedsecurities for the first half of 2005-06 which set gross borrowings throughissuance of dated securities at Rs.83, 000 crore. All issuances of datedsecurities were by way of fixed coupons in response to the favourable marketappetite for such securities. During the second half, however, out of the twoauctions scheduled in the indicative calendar of dated securities on October 6,2005 all bids received in respect of one auction were rejected. On a review ofthe borrowing requirements, the auction of dated securities scheduled forOctober 18-25, 2005 for an amount of Rs.4, 000 crore was cancelled inconsultation with the Central Government. The weighted average yield on freshborrowings through dated securities increased to 7.29 per cent (up to October21), up from 5.76 per cent in the corresponding period last year. The weightedaverage maturity of dated securities of the Central Government increased to15.1 years from 14.3 years over the same period. All issuances during thecurrent financial year, except one, were reassurances reflecting effortstowards consolidation of public debt and imparting liquidity to the Governmentsecurities market. As against the provisional net allocation of Rs.16, 112crore (gross Rs.22, 431 crore) for their market borrowing programme, the StateGovernments have raised Rs.6, 274 crore (net) and Rs.14, 265 crore (gross) upto October 21, 2005.

16. During 2005-06so far (up to October 14, 2005), additional liquidity of Rs.4, 065 crore wasabsorbed under the MSS. Notwithstanding the MSS operations, surplus liquidityconditions resulted in the reverse repo volumes tendered under the LAFincreasing from an average of Rs.29, 809 crore in March to Rs.34, 832 crore inAugust before declining to Rs.21, 128 crore in October 2005. Up to July, theabsorption of liquidity through the MSS was more than offset by decreasingreverse repo levels. Thereafter, LAF reverse repo increased sharply asliquidity conditions eased with the resumption of inflows from abroad. LargeMSS redemption in September resulted in accretions under LAF and absorptionthrough acceptance of higher bids under fresh auctions. In addition to the MSSand the LAF, surplus balances in the Central Government account with theReserve Bank rose from an average of Rs.5, 142 crore in April-October 2004 toRs.18, 643 crore in April-October 2005 and also helped in sterilizing excessliquidity from time to time. Accordingly, the total liquidity that remainedsterilized (in the form of MSS, LAF and surplus balances of Central Government)increased from an average of about Rs.1, 14,192 crore in March to Rs.1, 23,844crore in August before declining to Rs.1, 20,076 crore in October 2005.

17. The revenuedeficit and gross fiscal deficit (GFD) of the Central Government at Rs.74, 372crore and Rs.86, 328 crore, respectively, during April-August, 2005 accountedfor about 78.0 per cent and 57.1 per cent of the budget estimates for 2005-06as compared with 82.6 per cent and 38.2 per cent, respectively, in thecorresponding period of 2004-05. During April-August 2005, the revenue deficitof the Centre was higher by 18.2 per cent than its level in the correspondingperiod of the previous year while the GFD was higher by 64.4 per cent. Adjustedfor transactions under the discontinued debt swap scheme, the GFD was higher byonly 8.1 per cent than its level a year ago.

18. Themarket-borrowing programme of the Centre and the States envisaged for 2005-06is higher than in the previous year. Superimposed upon the underlying liquidityconditions and shifts in banks’ portfolio preferences in favour of credit ascompared with investments, this has entailed some hardening of yields.Continued large borrowings from the market by the Centre and the States poseconcerns for the efficient conduct of debt management as well as for monetaryoperations. In this context, the renewed commitment to fiscal consolidationthrough reduction in the revenue deficit and the gross fiscal deficit at alllevels of Government and the diffusion of fiscal responsibility legislation atthe sub-national level is heartening. States’ budgets for 2005-06 havegenerally not taken into account the recommendations of the Twelfth FinanceCommission (TFC) relating to devolution, transfers and debt relief. With thephasing out of Central Plan Loans to the States as recommended by the TFC, themarket borrowings of the States is not likely to be out of alignment with thenet allocation for 2005-06 in the light of higher devolution of taxes andgrants from the Centre to the States and larger receipts from the nationalsmall saving fund (NSSF).

19. Scheduledcommercial banks’ investment in government and other approved securities atRs.14,283 crore during the current year so far (up to September 30, 2005) waslower than that of Rs.28,526 crore in the corresponding period of the previousyear, partly on account of the pick-up in credit demand. There has beensubstantial support for the market-borrowing programme from non-bank entities.Commercial banks’ excess holding of SLR securities stood at Rs.2,24,701 crore.

20. Financialmarkets have remained stable and orderly although interest rates have firmed upin almost all segments. The average call money rate increased from 4.77 percent in April to 5.06 per cent in October 2005 (up to October 21) although ithas generally remained closely aligned with the LAF reverse repo rate. The91-day and the 364-day Treasury bill rates also increased from 5.12 per centand 5.60 per cent in April to 5.53 per cent and 5.85 per cent, respectively, byOctober 2005. The 182-day Treasury bill rate has moved up from 5.21 per cent to5.78 per cent during this period. The yield on government securities with1-year residual maturity in the secondary market increased from 5.66 per centto 5.88 per cent. The yield on government securities with 10-year and 20-year residualmaturities increased from 6.68 per cent and 7.08 per cent to 7.18 per cent and7.52 per cent, respectively. With a relatively higher increase in the long-termyields, there was a steepening of the yield curve. The yield spread between10-year and 1-year government securities moved up from 102 basis points to 130basis points whereas the spread between 20-year and 1-year governmentsecurities increased from 142 basis points to 164 basis points.

21. The weightedaverage discount rate on commercial paper (CP) of 61 to 90-days maturityincreased from 5.80 per cent in April to 5.89 per cent by mid-October 2005. Themarket repo rate increased from 4.63 per cent to 4.85 per cent with an increasein daily volume from Rs.3,958 crore (one leg) to Rs.5,661 crore by September2005. The average daily volume of CBLO (collateralized borrowing and lendingobligation) increased significantly from Rs.5,185 crore to Rs.8,572 crore alongwith an increase in the CBLO rate from 4.58 per cent to 4.80 per cent. Thetypical interest rate on 3-month certificates of deposit (CDs) increased from5.87 per cent in April to 5.90 per cent by mid-September 2005. Public sectorbanks kept their rates for deposits of over one year maturity unchanged in therange of 5.25-6.50 per cent during April-September, 2005. The benchmark primelending rates (BPLRs) of public sector banks, private sector banks and foreignbanks remained unchanged in the range of 10.25-11.25 per cent, 11.00-13.50 percent and 10.00-14.50 per cent, respectively.

22. The risk premiumon private sector bonds, as measured by the yield spread between highly ratedcorporate paper and government securities, has increased. For example, theyield spread between AAA-rated corporate bonds of 5 years and governmentsecurities of similar maturity increased from about 34 basis points in April toabout 47 basis points by October 21, 2005.

23. Equity marketactivity recorded a pick-up in terms of issuances in the domestic primarysegment as well as in international stock exchanges. The BSE Sensex recoveredfrom weak sentiment in April and rallied with intermittent corrections in thesuccessive months. The Sensex rose to a new peak of 8800 on October 4, 2005after which it registered some decline.

Developments in theExternal Sector

24. India’s exportsduring April-September, 2005 increased by 20.5 per cent in US dollar terms ascompared with 30.8 per cent in the corresponding period of the previous year.India’s merchandise export growth surpassed that of most Asian countries duringthis period. Imports rose by 33.1 per cent as against an increase of 37.3 percent in the corresponding period last year. While oil import growth moderatedto 42.9 per cent from
58.2 per cent a year ago, non-oil import growth of 28.8 per cent was comparableto 29.8 per cent last year. The overall trade deficit duringApril-September 2005 widened to US $ 20.3 billion from US $ 11.9 billion a yearago, reflecting the hardening of international crude oil prices and moresignificantly, import demand emanating from a pick-up in domestic industrialactivity.

25. DuringApril-August, 2005-export growth was broad-based at a disaggregated level, butmainly led by manufactures such as engineering goods (28.9 per cent), gems andjewellery (23.9 per cent) and chemicals (21.8 per cent). Within engineeringgoods, machinery and instruments, transport equipment and manufactures ofmetals recorded acceleration of growth. Exports of petroleum products remainedbuoyant as in the preceding two years. Exports to developing countries in Asiaincreased by about 34.4 per cent. Among the major partner countries,significant increases in exports were recorded in respect of Latin America,Singapore, China, South Korea, Hong Kong, the Netherlands, France and the UK.As regards imports, non-oil imports excluding gold and silver rose by 36.7 percent during April-August, 2005 led by imports of industrial inputs. Within thelatter category, imports of capital goods posted a growth of 33.5 per cent,while imports of iron and steel surged by 109.9 per cent, both reflecting thesustained expansion of domestic demand. In terms of sources of imports, China,Switzerland, the US, Belgium, Germany, the UAE and Australia were the majortrade partners. With the large expansion in non-oil imports, the non-oil tradedeficit rose to US $ 4.8 billion in April-August, 2005 from US $ 0.2 billion ayear ago.

26. During 2004-05,the current account recorded a deficit of US $ 6.4 billion after remaining insurplus over the preceding three years beginning in 2001-02. A key factorunderlying the phenomenon of current account balances has been the buoyancy innet invisible earnings, which has been sustained in the current financial yearso far. Nevertheless, the sharp widening of the trade deficit resulted in thecurrent account recording a deficit of US $ 6.2 billion in April-June 2005 asagainst a surplus of US $ 3.4 billion in the corresponding quarter of 2004-05.

27. Net capitalflows remained buoyant in April-June, 2005 due to surge in both debt andnon-debt inflows. Foreign direct investment flows increased to US $ 1.1 billionfrom US $ 0.7 billion a year ago. Debt flows (net) in the form of externalassistance, external commercial borrowings, non-resident deposits andshort-term credit declined to US $ 1.1 billion in April-June 2005 from US $ 2.1billion a year ago. Although investment by foreign institutional investors(FIIs) was subdued in the first two months of 2005-06, there has been asignificant revival since then with net inflows of US $ 4.2 billion in
April-September, 2005 as against US $ 0.3 billion in the corresponding periodof 2004-05. Net accretion to foreign exchange reserves, including valuationchanges, amounted to US $ 1.9 billion during April-October, 2005 taking thelevel of the reserves to US $ 143.4 billion as on October 14, 2005.

28. The Indianforeign exchange market has generally witnessed orderly conditions during thecurrent financial year so far. The exchange rate of the rupee, which wasRs.43.75 per US dollar at end-March, 2005 depreciated by 3.0 per cent toRs.45.09 per US dollar by October 21, 2005. However, it appreciated by 4.2 percent against the Euro, by 2.5 per cent against the Pound sterling and by 4.5per cent against the Japanese yen during the period.

29. The paymentobligation on account of the redemption of India Millennium Deposits (IMDs) ofabout US $ 7.1 billion is due in December 2005. The Reserve Bank is closelyco-ordinating with the State Bank of India (SBI) and other banks, and it wouldbe ensured that the discharge of liabilities has no adverse impact on theIndian financial market.

30. There aresignificant shifts within the balance of payments, which have implications forthe conduct of monetary policy. With the import-GDP ratio having risen to 17.2per cent in 2004-05 after hovering around 13.0 per cent during the previousfive years, the trade deficit is emerging as the key determinant of India’sbalance of payments. Although overall earnings from net invisibles have beenbuoyant, the large turnaround in the current account balance during 2004-05 andthe first quarter of 2005-06 to a deficit from a continuous run of surpluses in2001-04 has entailed expanded external financing requirements in the form of astep-up in recourse to debt flows and a distinct moderation in the accretion tothe reserves.

31. The strength ofmerchandise and invisible exports is a heartening feature in India’s balance ofpayments prospects. While the recent trend in imports may continue to persistin the face of high and volatile crude oil prices and the large increase ininvestment demand, the sizeable expansion in imports is also spurringproductivity increases and vigorous export growth. Moreover, remittances fromIndians employed abroad at 3.3 per cent of GDP seem to be of a significantly permanentnature. It is in this context that the current level of the trade deficit andthe current account deficit appear to be manageable through normal capitalflows. In view of the simultaneous hike in oil prices and continued stronginvestment demand, however, the evolving developments in the balance ofpayments warrant careful and continuous monitoring. The substitution of debt bynon-debt flows in preceding years gives room for manoeuvre since debt levels,particularly external commercial borrowings, have been moderate. The emphasiswould continue to be on encouraging inflows through foreign direct investmentand enhancement of the quality of portfolio flows. Prudential oversight overfinancial intermediaries, especially banks, in respect of their foreignexchange exposures and transactions are a dynamic component of management ofthe capital account as well as financial supervision, especially as the processof financial liberalization gains momentum.

Developments in theGlobal Economy

32. Global economicactivity slackened in the second quarter of 2005, stalled by weak growth in theEuro area and Japan though domestic demand was sustained in the US. In emergingAsia - led by China and India - as well as in several developing countries inLatin America, the Middle East and Russia, growth has been robust. High andvolatile international crude prices, global macroeconomic imbalances,international currency movements and the increasingly divergent growth profilesacross regions have dampened the prospects for global recovery which had firmedup in the first half of 2004 and in the first quarter of 2005. TheInternational Monetary Fund (IMF) expects global output growth to slow down, albeitmoderately, to 4.3 per cent in 2005 from 5.1 per cent in 2004.

33. Elevated levelsof international crude prices have driven up consumer price inflation in mostof the advanced economies in the third quarter of 2005 though it has remainedstable in Japan. Inflation has also risen in major emerging market economiesand other developing countries. In emerging Asia, consumer price inflation hasedged up in almost all countries except China. The hardening of energy, metalsand minerals prices seems to have imparted some upward push to inflation. Therise in oil prices has triggered fears of generalized inflationary pressuresglobally.

34. Oil pricesremain the single largest risk to the global economy, exacerbated by thecontinued increase in global demand, geopolitical uncertainties, strongrefining demand and a series of supply disruptions. Worldwide petroleum demandgrowth is projected to remain strong during 2005 and 2006 and tepid productiongrowth is expected in non-OPEC countries, leaving spare production capacity atits lowest level in three decades. Though there has been build-up in inventorylevels in the OECD countries in the first half of 2005, demand has grownrapidly as well. A large component of the oil price increase is now beingreckoned as permanent, which needs to be eventually passed on to the consumersin the medium-term. Governments in some countries have tried to partiallyinsulate their economies from rising oil prices by subsidising the use ofenergy. A cut in the subsidy in the future, while being desirable, could leadto significant increase in domestic inflation and higher interest rates in theshort-term.

35. Risks to globalgrowth also emanate from the persisting macroeconomic imbalances and theresulting abundance of global liquidity which carries the potential of fuellingasset bubbles, excessive leveraging in financial markets and threats to globalfinancial stability. The current configuration of good growth, low inflation,abundant liquidity, flat yield curves, lowering of credit risk premia andever-expanding search for yields has also benefited many emerging marketeconomies which have strengthened their macro-fundamentals in an environment oflow inflation, improved fiscal positions and balance of payments andsubstantial accumulation of foreign exchange reserves. On the downside, thesame combination of factors has allowed the macro imbalances to widen and hasresulted in a build-up of large volumes of debt, especially by the householdsector. This has amplified the potential for sudden shifts in portfolios,investor preferences and currency alignments. The addition to global saving asa result of the increase in surpluses of oil exporters has enabled persistenceof under-pricing of risks and a diffusion of risks across sectors. Thesefactors have imparted an apparent stability to the financial system whilesowing seeds of potential disequilibrium that might require a larger adjustmentat a later stage. In the light of these developments, available evidenceindicates that global imbalances have not really unwound but on the contrary,have perhaps worsened and amplified the surrounding uncertainties and risks.

36. Of the majorcentral banks, the US Fed has raised its policy rate by 25 basis points each oneleven occasions from 1.0 per cent in June 2004 to 3.75 per cent by September2005 while providing clear indications of a measured rise in the policy rate inthe near term. The Bank of England has reduced its repo rate to 4.50 per centin August 2005 in response to slowing domestic growth, after holding it steadyat 4.75 per cent since August 2004. The European Central Bank (ECB) has keptits policy rate unchanged at 2.0 per cent since June 2003. Monetary policy hasbeen tightened in several economies in emerging Asia, primarily in response tohigher fuel prices. The indications in policy debates are towards eithertightening or withdrawal of the accommodative stance.

37. The state offlux characterizing global macroeconomic and financial conditions hasconfronted the conduct of monetary policy in various parts of the world with asimilar spectrum of uncertainties and shifts therein. In fact, policydecision-making in all countries has had to contend with difficulties ofdistinguishing news from noise in monitoring variables that are used to gaugethe state of economic activity and the evolution of financial markets. This hasmade the dilemmas facing monetary policy sharper and policy errors costlierthan before. In turn, this has brought about considerable cross-fertilisationand convergence in policy settings, choice of instruments and communication strategies.For monetary authorities vested with multiple objectives, the challenge is tocontinually rebalance the weights assigned to each, from as informed a judgmentcall as is feasible, given the prevailing uncertainties. Considerations offinancial stability have, in particular, become a distinct dimension in theconventional trade-off between growth and price stability. Superimposed uponthese overarching issues are country-specific factors, which warrant tailoredpolicy responses. For India, the linkages with the rest of the world in thecontext of the growing integration with the global economy are getting strongerand accordingly, global developments are becoming increasingly significant.Nevertheless, the evolution of domestic conditions of high growth with pricestability, stable and vibrant financial markets and institutions, comfortableforeign exchange reserves and the entrenchment of democratic processes provideroom for flexible and timely responses to the evolving circumstances in anuncertain external environment.