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Introduction

The Reserve Bank of India (RBI) is thecentral bankinginstitution ofIndiaand controls the

monetary policy of therupeeas well asUS$300.21 billion (2010) ofcurrency reserves. The

institution was established on 1 April 1935 during theBritish Rajin accordance with the

provisions of the Reserve Bank of India Act, 1934. The share capital was divided into shares

of Rs. 100 each fully paid which was entirely owned by private shareholders in the

beginning. Reserve Bank of India plays an important part in the development strategy of the

government. It is a member bank of theAsian Clearing Union. Reserve Bank of India was

nationalised in the year 1949. The general superintendence and direction of the Bank is

entrusted to Central Board of Directors of 20 members, the Governor and four Deputy

Governors, one Government official from the Ministry of Finance, ten nominated Directors

by the Government to give representation to important elements in the economic life of the

country, and four nominated Directors by the Central Government to represent the four local

Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Boards

consist of five members each Central Government appointed for a term of four years to

represent territorial and economic interests and the interests of co-operative and indigenous

banks
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Monitory policy

2. The Annual Policy for 2011-12 is set in conditions significantly different from those a year ago. Last

years policy was made in an environment of incipient domestic recovery and uncertainty about the

state of the global economy. While signs of inflation were visible, they were driven primarily by food

items. Nonetheless, there was a clear risk of food price pressures spilling over into more generalised

inflation, as the recovery consolidated and domestic resource utilisation rose to levels which stretched

capacities. Throughout last year, the goal of monetary policy was to nurture the recovery in the face of

persistent global uncertainty, while trying to contain the spill-over of supply side inflation.

3. The Reserve Bank followed a policy of calibrated tightening last year. This was justified by the

trend of moderating inflation and consolidating growth in the second and third quarters of 2010-11.

However, the resurgence of inflation in the last quarter of last year became a matter of concern.

Although the trigger for this was the sharp uptrend in international commodity prices, the fact that

these have quickly passed through into the entire range of domestic manufactured goods indicates

that pricing power is significant. In other words, demand has been strong enough to allow significant

pass-through of input price increases. Importantly, this is happening even as there are visible signs of

moderating growth, particularly in capital goods production and investment spending, suggesting that

cumulative monetary actions are beginning to have an impact on demand.

4. Thus, three factors have shaped the outlook and monetary strategy for 2011-12.

First, global commodity prices, which have surged in recent months are, at best, likely to

remain firm, and may well increase further over the course of the year. This suggests that

higher inflation will persist, and may indeed get worse.

Second, headline and core inflation have significantly overshot even the most pessimistic

projections over the past few months. This raises concerns about inflation expectations

becoming unhinged.

The third factor, one countering the above forces, is the likely moderation in demand, which

should help reduce pricing power and the extent of pass-through of commodity prices. This

contra trend cannot be ignored in the policy calculation. However, a significant factor

influencing aggregate demand during the year will be the fiscal situation. The budget

estimates offered reassurance of a fiscal rollback. However, the critical assumption, that

petroleum and fertiliser subsidies would be capped, is bound to be seriously tested at

prevailing crude oil prices. Even though an adjustment of domestic retail prices may add to

the inflation rate in the short run, the Reserve Bank believes that this needs to be done as


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soon as possible. Otherwise, the fiscal deficit will widen and will counter the moderating trend

in aggregate demand.

5. The monetary policy trajectory that is being initiated in this Annual Statement is based on the

following basic premise. Over the long run, high inflation is inimical to sustained growth as it harmsinvestment by creating uncertainty. Current elevated rates of inflation pose significant risks to future

growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take

precedence.

Monetary Policy Stance

6. Against the above backdrop, the stance of monetary policy of the Reserve Bank will be as follows:

First, to maintain an interest rate environment that moderates inflation and anchors inflation

expectations.

Second, to foster an environment of price stability that is conducive to sustaining growth in the

medium-term, coupled with financial stability.

Third, to manage liquidity to ensure that it remains broadly in balance, with neither a large

surplus diluting monetary transmission nor a large deficit choking off fund flows.

Changes in Operating Procedure of Monetary Policy

7. Before announcing our policy measures, let me make a comment on the changes we are making to

the operating procedure of monetary policy.

8. Last July, the Reserve Bank constituted a Working Group to Review the Operating Procedure of

Monetary Policy. The report of the Group, chaired by our Executive Director, Deepak Mohanty, was

put out in the public domain in March 2011 inviting feedback and comments.

9. Based on the Groups recommendations, and in light of the feedback received, it has been decided

to make the following changes to the operating procedure of monetary policy:

First, the weighted average overnight call money rate will be the operating target of monetary

policy of the Reserve Bank.

Second, there will henceforth be only one independently varying policy rate, and that will be

the repo rate. This transition to a single independently varying policy rate is expected to more

accurately signal the monetary policy stance.

Third, the reverse repo rate will continue to be operative, but it will be pegged at a fixed 100

basis points below the repo rate. Hence, the reverse repo rate will no longer be an

independent variable.

Fourth, we will be instituting a new Marginal Standing Facility (MSF). Banks can borrow

overnight from the MSF up to one per cent of their respective net demand and time liabilities


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or NDTL. The rate of interest on amounts accessed from this facility will be 100 basis points

above the repo rate.

As per the above scheme, the revised corridor will have a fixed width of 200 basis points. The

repo rate will be in the middle. The reverse repo rate will be 100 basis points below it, and the

MSF rate 100 basis points above it.

10. These changes in the operating framework, except that pertaining to the MSF, will come into force

immediately. The MSF will come into effect from the fortnight beginning 7th May, 2011.

Monetary Measures

11. On the basis of the policy stance that I outlined above, and in accordance with changes in

operating procedure as set out, we have decided to take the following policy measures:

i. The repo rate under the liquidity adjustment facility (LAF) has been increased by 50 basis

points. Accordingly, it goes up from 6.75 per cent to 7.25 per cent.

ii. As per the new operating procedure, the reverse repo rate under the LAF, determined with a

100 basis point spread below the repo rate, will stand adjusted at 6.25 per cent.

iii. The Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points

above the repo rate, gets calibrated at 8.25 per cent.

iv. The Bank Rate remains at 6.0 per cent.

v. The cash reserve ratio (CRR) remains unchanged at 6 per cent of NDTL of scheduled banks.

Savings Bank Deposit Interest Rate

12. Let me now turn to the savings bank deposit interest rate on which there has been a lot of media

comment over the last week. A week ago, the Reserve Bank put out a discussion paper debating the

pros and cons of this proposal. We will review the policy of deregulating the savings bank deposit rate

based on the feedback that we get.

13. Pending a final decision on that, we have decided to increase the savings bank deposit interest

rate from the present 3.5 per cent to 4.0 per cent with immediate effect.

Expected Outcomes

14. As regards outcomes, the above monetary policy actions are expected to:

First, contain inflation by reining in demand side pressures, and anchor inflation expectations;

and

Second, the actions are expected to sustain growth in the medium-term by containing

inflation.


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15. Let me give you some guidance for the period forward. The Reserve Bank's baseline inflation

projections are that inflation will remain elevated, close to the March 2011 level over the first half of

2011-12, before declining. These projections factor in an upward revision of petrol and diesel prices.

While the persistence of inflation over the next few months has been incorporated into this policy, the

Reserve Bank will continue to persevere with its anti-inflationary stance.

Overview

16. I now want to give you an overview of the global and domestic macroeconomic developments that

guided our monetary policy stance, and our growth and inflation projections.

Global Outlook

17. On the global front, recovery is expected to sustain in 2011 even as it is projected to moderate

marginally from its 2010 pace due to the phasing out of the fiscal stimulus, and high oil and other

commodity prices. Growth in emerging market economies is also expected to decelerate on account

of monetary tightening and rising commodity prices. Theadvanced economies are facing inflation

pressures from high commodity prices, while inflation pressures for the emerging market economies

are stemming from both strong domestic demand and high commodity prices.

The Indian Economy

Growth

18. Turning to the domestic macroeconomic situation, the Indian economy is estimated to have grown

by 8.6 per cent last year. Agricultural growth was above trend, following a good monsoon. The index

of industrial production (IIP), which grew by 10.7 per cent during the first half of last year, moderated

subsequently, bringing down the overall growth for April-February 2010-11 to 7.8 per cent. Particularly

significant were the slowdown in capital goods production and investment spending.

19. Going forward, high oil and other commodity prices and the impact of the Reserve Banks anti-

inflationary monetary stance will moderate growth. Based on the assumption of a normal monsoon,

and crude oil prices averaging US$110 a barrel over the full year 2011-12, our baseline projection of

real GDP growth for 2011-12, for policy purposes, is around 8 per cent.

Inflation

20. Inflation has been, and remains, a primary macroeconomic concern. Last year, inflation was

driven by a combination of structural and transitory factors. Based on drivers of inflation, the year

gone by, could broadly be divided into three periods.


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In the first period from April to July 2010, WPI increased by 3.5 per cent, and this was driven

largely by food items.

During the second period from August to November 2010, WPI increase decelerated to 1.8

per cent, with the major driver being non-food primary articles.

In the third period, from December 2010 to March 2011, WPI increased sharply by 3.4 per

cent, driven primarily by non-food manufactured products.

Inflation pressures, which initially emanated from food, clearly became generalised as the

year progressed.

21. Going forward, the inflation outlook will be shaped by the following factors:

The first factor is, when administered fuel and power group prices might be revised and by

how much.

Second, the outlook for crude oil prices in the near future is uncertain given the geopolitical

situation in the Middle East and North Africa. In any case, the likelihood of oil prices

moderating significantly is low.

The third factor that will shape the inflation outlook is the sharp increase in the prices of

several important industrial raw materials such as minerals, fibres, rubber, coal and crude oil.

In addition, there is also upward pressure on wages. To the extent the increase in input prices

translates to output prices, it will have an influence on the inflation path.

Finally, the behaviour of the monsoon will be a critical factor in shaping inflation expectations

on the way forward.

22. Keeping in view the domestic demand-supply balance, the global trend in commodity prices, and

the likely demand scenario, our baseline projection for WPI inflation for March 2012 is 6 per cent with

an upward bias.

23. As regards the trajectory over the year, inflation is expected to remain at an elevated level in the

first half of the year, before gradually moderating to 6 per cent by March 2012. This trajectory is

conditional on appropriate policy actions over the year.

Monetary and Liquidity Conditions

24. Liquidity conditions remained abnormally tight for much of last year owing to a combination of

structural and frictional factors. The LAF corridor stayed almost entirely in the injection mode during

the year. You will recall that the Reserve Bank had instituted a number of measures to ease the

excessive tightness in the system.

25. Liquidity conditions have eased significantly in recent weeks, following a sharp reduction in

government cash balances, and moderation in the credit-deposit ratio of banks. The liquidity situation

is now within the comfort zone of the Reserve Bank.


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External Sector

26. A brief, albeit important, comment about the external sector. Exports showed remarkable

buoyancy in the last quarter of last fiscal. The current account deficit (CAD) was 3.1 per cent of GDP

for the first three quarters, April-December 2010. Factoring in the better performance in the lastquarter, CAD is now estimated to have moderated toaround 2.5 per cent of GDP for the full year,

2010-11 as compared with 2.8 per cent for the year before, 2009-10.

Risk Factors

27. Now let me highlight the risks to our growth and inflation projections:

First, there are several downside risks to global growth at this stage such as: (a) sovereign

debt problem in the euro area, (b) high commodity prices, especially oil prices, (c) possible

abrupt rise in long-term interest rates in advanced economies with implications for fiscal

adjustment; and (d) accentuation of inflationary pressures in emerging market economies.

Should the global recovery slacken because of any or some of these factors, it will impact our

economy through trade, finance and confidence channels.

Second, global commodity prices are a significant risk factor for both domestic growth and

inflation. The future path of crude oil prices is uncertain.

Third, the budgeted fiscal deficit for the current year gives some comfort on the demand front.

However, the achievement of the fiscal targets set out in the budget could be challenged by

the higher subsidy burden stemming from higher international crude oil prices.

Fourth, persistently high food prices are likely to exert sustained upward pressure on wages,

thus transmitting through to wider cost pressure on prices.

Finally, if oil and commodity prices remain elevated, both the level of current account deficit,

and its financing could pose a challenge.


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Developmental and Regulatory Polices

28. As is the standard practice, this Annual Monetary Policy Statement also includes developmental

and regulatory policies. Let me briefly touch upon some of the important initiatives.

29. I will start with the Malegam Committee Report on Regulation of Micro Finance Institutions.

The Reserve Bank has broadly accepted the framework of regulations recommended by the

Malegam Committee. We have, however, adjusted some of the parameters recommended by

the Committee.

Bank loans to all MFIs, including NBFCs working as MFIs on or after April 1, 2011, will be

eligible for classification as priority sector loans if, and only if, they conform to the regulations

formulated by the Reserve Bank.

As recommended by the Malegam Committee, the Reserve Bank has also decided to appoint

a Committee to review the priority sector lending classification

30. A broad goal driving our financial inclusion initiative is to provide banking access to all villages

with population of over 2000 by March 2012. There are 72,800 villages identified as falling into this

category. We are asking banks to ensure that at least 25 per cent of the new branches being opened

during this year are located in tier 5 and tier 6 centres.

31. In the area of financial markets, there are three important initiatives:

First, the Reserve Bank will shortly issue the final guidelines on credit default swaps.

Second, the period of short sale in government securities will be extended from the existing

five days to a maximum of three months.

Third, FIIs will be allowed to cancel and rebook up to 10 per cent of the market value of the

portfolio as at the beginning of the financial year.

32. Moving on to regulatory measures for commercial banks, I want to highlight two measures:

First, the provisioning requirements on certain categories of non-performing advances and

restructured advances will be enhanced.

Second, investment by banks in liquid schemes of debt oriented mutual funds will be subject

to a prudential cap of 10 per cent of their net worth as on March 31 of the previous year.

33. I invite you to please read the policy document for a full listing of our developmental and

regulatory measures.


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34. Before I close, I want to reiterate what I said earlier, by making a brief comment on the growth-

inflation trade off, an issue that has been widely debated in the run up to this policy. High and

persistent inflation undermines growth by creating uncertainty for investors, and driving up inflation

expectations. An environment of price stability is a pre-condition for sustaining growth in the medium-

term. Reining in inflation should therefore take precedence even if there are some short-term costs byway of lower growth".

Foreign policy

The Reserve Bank of India (RBI) has announced some policy measures as follows:

1. Issue of Shares for Consideration Other Than Cash

In its recent foreign direct investment (FDI) policy, the Government of India hadannounced

additional methods for issue of shares for consideration other than cash, such as: (a) import of

capital goods/ machinery/ equipment (including second-hand machinery); (b) pre-operative/

pre-incorporation expenses (including payments of rent, etc.). The RBI has nowimplemented

these schemes by prescribing the detailed conditions on which this share issuance facility will

be available to Indian companies.

2. Extension of Time for Buyback of FCCBs

Several investors holding foreign currency convertible bonds (FCCBs) in Indian companies

have not exercised their conversion options because the prevailing market prices of

underlying shares are lower than the conversion price. In order to provide exit options to such

investors, the RBI has been permitting buyback of FCCBs by Indian companies. The facility

has now beenmade availableuntil March 2012, both under the automatic route as well as the

approval route. Some of the policy reasons behind this move are reported in theTimes of

Indiaand theHindu Business Line.

Credit policy

The last thing the economy needs is a central bank that is not showing confidence in itself.

The past one year has been a tough one for the economy. Inflation has been confounding

everyone from policy makers to economists. Inflation forecasts have gone horribly wrong

with inflation consistently trending higher than forecasts. Inflation as measured by the WPI

(Wholesale Price Index) at levels of 9.44% is higher by at least 200bps from even the most

pessimistic of forecasters. The RBI had gone wrong in its forecasts of inflation and did not
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recognize the inflation threat until too late. RBI had to revise forecasts from 6% levels to 9%

levels over the last six months. The sharp revision in inflation forecast prompted two rounds

of rate tightening in May and June totaling 75bps. Inflation at present is expected to stay over

9% levels for the next few months before trending down.

RBI has raised the repo rate cumulatively by 275bps over the last fifteen months to bring

down inflation expectations. Yet, no one, from policy makers to economists to business

leaders is standing up and saying that inflation is peaking. This is because of previous

forecasts going completely wrong. In such a scenario where pessimism rules and no one is

confident of the future trajectory of macro economic variables, the investment climate

suffers. There tends to be a wait and watch policy where businesses put off investments and

consumers put off consumption. This leads to a self-fulfilling spiral of a downward trajectory

in economic growth variable.

In such a scenario the RBI must be the leader. It must stand up and confidently say that the

past anti inflationary policies is taking effect and that inflation is peaking out. It has admitted

its earlier mistakes but that does not mean it will go on making mistakes. RBI has stood out

in the past in taking bold steps especially during the years leading to the credit crisis of 2008

and it can take firm calls now.

The best show of confidence in the policy review on the 26th of July 2011 will be a pause in

policy rate hikes. If the RBI pauses and states that inflation is under control there cannot be a

better confidence booster to the stakeholders in the Indian economy. Even if the RBI raises

rates by 25bps and indicates inflation is under control, it will be a show of confidence.

The worst show of confidence is a rate hike accompanied by uncertainty on inflation. It

shows that the RBI does not have confidence in itself at present and that sends out wrongsignals to the economy.

We are all waiting for RBI to provide the confidence booster.

Green policy


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Green policies hurting FDI,says RBI

TNN Jan 25, 2011, 08.23am IST

MUMBAI: The RBI has said that environment sensitive policies and procedural delays arehurting foreign direct investment.

The moderation in FDI inflows toIndiaduring April-November 2010 has been driven bysectors such as construction,mining and business services.A major reason for the decline ininward FDI is reported to have been the environment sensitive policies pursued,as manifestedin the recent episodes in the mining sector,integrated township projects and construction ofports,which appear to have affected the investors sentiments,the RBI said The report adds

that persistent procedural delays,land acquisition issues and availability of qualityinfrastructure have added to the environment related issues.These factors,which are morestructural in nature,if addressed expeditiously,could raise the share of India in the projectedFDI flows to EMEs in the near future,the RBI said.

The central bank said that while the subdued growth of services receipts is cyclical in nature

and can be expected to resolve with the global recovery becoming more broad-based and

robust,the rise in crude oil prices and reasons for moderation in FDI are more structural in

nature.Since supply of crude oil is relatively inelastic,the economy needs to adjust itself in the
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medium-term by investing in the use of non-conventional sources of energy.As regards FDI

flows,the reform process needs to be expedited to address the impediments,it said.

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