The RBI announced its Second Quarter Review of Monetary Policy for the Year 2009-10 today and as expected, has left the key rates unchanged. Though the RBI kept key rates unchanged, it hiked Statutory Liquidity Ratio (SLR), the deposits that commercial banks are to park in government securities, by one percentage points to 25 per cent.

While this should have brought some cheer to the markets, they plunged deeper into the red not only because the RBI looks set to raise interest rates going forward, but also because the central bank has upwardly revised its target inflation by March 2010 end to 6.5% from 5% earlier.

The upward bias in interest rates was apparent from the RBI's move to hike the statutory liquidity ratio (SLR) to 25% from 24%. Having said that, whether interest rates in the future rise or not will depend on whether the inflation continues to rise the way it is doing now, and the economic momentum continues to pick up pace.

Meanwhile, real estate companies are set to face some challenging times ahead. This is because the RBI has indicated its worry about rising property prices by increasing the provisioning requirement for advances to the commercial real estate sector from 0.4% to 1%. This is surely going to hit realty companies that are looking to borrow from the banks to fund their commercial real estate development plans. Not only will the RBI's SLR move action make it difficult for realty companies to get sufficient loans, the higher provisioning norms will also likely raise their interest costs on such loans.

Introduction:

The global economy has begun to recover from the deep recession set off by the financial crisis. This recovery is underpinned by output expansion in emerging market economies (EMEs), particularly those in Asia. The pace and shape of recovery, however, remain uncertain.

2.         In fact, the global economic outlook presents a mixed picture. On the positive side, world output, as per the International Monetary Fund (IMF) estimates, has expanded by 3 per cent in the second quarter (quarter-on-quarter, annualised), manufacturing activity has picked up, trade is recovering, financial market conditions are improving, and risk appetite is returning. A sharp recovery in equity markets has enabled banks to raise capital to repair their balance sheets. In the US, home prices appear to be stabilising. Capital flows to EMEs have resumed. Most importantly, the anxiety and nervousness that pervaded the financial markets during the height of the crisis are being replaced by a sense of calm.

3.         On the negative side, there are concerns that the recovery is fragile. The second quarter improvement is essentially the outcome of policy-induced stimulus. Going forward, the impact of the stimulus will fade away and inventory rebuilding may lose momentum. In advanced economies, private consumption remains constrained by continuing job losses, sluggish income growth and dented confidence. Even as output is recovering, unemployment is expected to increase to over 10 per cent in the US and the Euro area. Investment is also expected to remain weak due to ruptured balances sheets, excess capacity and financing constraints. Bank collapses are continuing. World trade remains below its year ago level, notwithstanding recent quarter-on-quarter improvement. 

4.         Reflecting this mixed trend which has a small bias towards the positive, the IMF projected, in its October 2009 World Economic Outlook (WEO), that the rate of contraction of the world economy in 2009 will be 1.1 per cent, an upward revision from its projection of a contraction of 1.4 per cent made in its July 2009 WEO. However, the IMF expects the ensuing global recovery to be slow. In its latest Economic Outlook (September 2009), the Organisation for Economic Co-operation and Development (OECD) projects the pace of activity to remain weak well into 2010 on account of numerous headwinds. On balance, while global economic prospects have improved since the First Quarter Review in July 2009, uncertainties remain about the pace and sustainability of economic recovery.

5.         The Indian economy, which slowed down significantly during the second half of 2008-09, largely due to the knock-on effect of the global financial crisis, has begun to stabilise. This is despite the continuing contraction in exports and the worst drought since 1972. Performance of the industrial sector has improved markedly in recent months. Both domestic and external financing conditions are on the upturn. Capital inflows have revived. Activity in the primary capital market has picked up and funding from non-bank domestic sources has eased. Liquidity conditions have remained easy and interest rates have softened in the money and credit markets. 

6.         At the same time, there are several negative indications. Private consumption demand is yet to pick up. Agricultural production is expected to decline due to lower Kharif foodgrain production. Services sector growth remains below trend. Bank credit growth continues to be sluggish. There are also clear signs of rising inflation stemming largely from the supply side, particularly from food prices. 

7.         This Second Quarter Review of Monetary Policy for 2009-10 is thus set against the backdrop of incipient signs of recovery in the global economy and improving prospects for the domestic economy. The Review is organised in two parts. Part A covers Monetary Policy andis divided into three sections: Section I provides an assessment of the Macroeconomic and Monetary Developments; Section II defines the Stance of Monetary Policy; andSection III sets out Monetary Measures. Part B coversthe Developmental and Regulatory Policies and is organised into seven sections: Financial Stability (Section I), Interest Rate Policy (Section II), Financial Markets (Section III), Credit Delivery Mechanism and other Banking Services (Section IV), Financial Inclusion (Section V), Regulatory Measures for Commercial Banks (Section VI) and Institutional Developments (Section VII). Part A of this Statement should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released yesterday.

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