PRESSURE POINTS

MONETARY POLICY MID-TERM REVIEW 2006-07

USA: A housing led-slowdown in the United States could open the door for a token Fed ease but market yields are likely to remain range-bound.

EURO ZONE: The European Central Bank is expected to hike official rates by 25 basis points in December to 3.50 per cent. However, a benign medium-term inflation outlook for the Euro region suggests that monetary policy will pause thereafter.

JAPAN: Solid export growth and resilience in private domestic demand point to sustained above-trend growth in Japan. The Bank of Japan is likely to resume normalisation of policy in the first quarter of 2007.

UNITED KINGDOM: The Bank of England's monetary policy committee is likely to hike rates again in November to 5 per cent and signal a further hike in early 2007.

CANADA: Downside risks to Canada's growth outlook have risen but risks to inflation are skewed to the upside.

AUSTRALIA: Upcoming inflation data holds the key to the Reserve Bank of Australia acting on its tightening bias.

CHINA: Strong GDP growth points towards further tightening, including faster yuan appreciation in China.

OTHER EMERGING MARKETS: Solid fundamentals have limited contagion from country shocks for other emerging markets, but tight asset prices leave little room for risks.

Real Indicators

For the quarter-ended June 2006, GDP rose 8.9 per cent with non-farm growth sustaining over 10 per cent for the second consecutive quarter. Despite agriculture coming in at 3.4 per cent, industry grew at 9.7 per cent y-o-y and services at 10.6 per cent, allowing India to maintain its position as the fastest growing economy after China.

Industry and services are expected to sustain at over 9 per cent levels.

This is largely due to investment upturn in corporate capex and infrastructure, new capacities in electricity generation and petroleum refineries, reversal of coal shortage and positive trends in consumer goods.

The buoyancy in services is likely to be sustained by a continued up trend in telecom subscribers, insurance premiums, tourism and freight traffic.

GDP is estimated at 8.3 per cent for the full year assuming a 3 per cent growth forecast for agriculture. Even if agricultural growth remains flat, GDP is estimated to grow at 7.7 per cent.

Money supply growth at 19.9 per cent has been far ahead of the 15.5 per cent target due to a rise in currency with the public, reflective of cash spending, and growth in deposits.

Inflation is now within the target of 5-5.5 per cent. Due to a favourable base impact, coupled with measures to curb prices, inflation should be benign in a 4.5-5.5 per cent range till December.

With the base effect wearing out by end-December, it is likely to cross 6 per cent. The government's borrowing calendar for the second of the year at Rs 63,000 crore is in line with the full year fiscal deficit of Rs 1,48,700 crore or 3.8 per cent of the GDP.

While the government has already issued Rs 14,000 crore oil bonds in FY07, if crude oil prices stay around $ 60/bbl, a Rs 8,000-10,000 crore reduction in issuance of oil bonds could be seen.

External sector

Imports, trade deficit as well as the current account deficit (CAD) reached record highs in the first quarter. While the CAD widened to an all-time quarterly high of $6.1 billion, its composition is indicative of ongoing economic activity.

Capital flows at $ 11.9 billion were more than sufficient to finance the CAD. This was due to higher loans led by external commercial borrowings and foreign currency convertible bonds and higher banking capital as a result of overseas borrowings.

RBI's recent norm allowing banks to raise capital funds through issue of foreign currency debt instruments is likely to sustain these numbers.

While the CAD is expected to widen to 1.9 per cent of GDP ($ 16.6 billion) from 1.3 per cent in FY06, continued momentum in capital flows and buoyant forex reserves at $ 166 billion, will support positive outlook on the external sector.

The recent downtrend in oil prices is likely to have a positive impact for the external account, domestic liquidity and interest rates, and a neutral effect on inflation.

A $ 1/bbl reduction in oil prices could reduce India's import bill by $700 million, resulting in a reduction in the current account deficit and a greater accretion to reserves. Higher accretion for reserves would be positive for domestic liquidity and rates. Another positive on the liquidity/rate front would be a lower issuance of oil bonds.

Theoretically, a $ 1/bbl change in oil prices impacts inflation by 30 basis point but this will not reflect in current inflation numbers as the price adjustment in the past was lower than required.