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

PART ONE : THE ECONOMY : REVIEW AND PROSPECTS

For the Year July 1, 2004 to June 30, 2005*

I ECONOMIC REVIEW

I. MACROECONOMIC POLICYENVIRONMENT

I.1.1 Global economic activityrecorded robust growth in the first half of2004 before encounter ing someslackening of pace in the second half ofthe year and in the first half of 2005. Thepossibility of downside risks arising fromhigh and volatile crude oil prices, recordmacroeconomic imbalances in the US,fears of disruptive currency adjustmentsand asset bubbles weighed upon theglobal recovery which had been firmingup since late 2003. Moreover, the recentdivergences in growth patterns becamemore pronounced in 2004 with the burdenof sustaining global growth gravitatingtowards the US, China and otheremerging and developing economies inAsia and Latin America. By contrast, inEurope and Japan – which account formore than a fifth of world GDP – growthstalled in the second half of 2004.Consumer pr ice inf lat ion remainedrelatively benign worldwide in 2004 andfinancial market condit ions turnedfavourable with ample liquidity and thecontinuing search for yields driving downrisk spreads. Global growth reached a 28-

year peak in 2004 and wor ld tradevolumes as well as net capital flows todeveloping economies returned to 1997(pre-East Asian cr isis) levels.Nevertheless, the persistence of the riskfactors and the potential impact of theupturn in the international interest ratecycle on consumer indebtedness andasset pr ices make macroeconomicprospects for 2005 somewhat lesssanguine than projected earlier. In itsApril 2005 World Economic Outlook, theInternational Monetary Fund (IMF) hastrimmed its forecast for global growth in2005 to 4.3 per cent from 5.1 per cent in2004.

I.1.2 Against this backdrop, the Indianeconomy recorded one of the highestgrowth rates in the world in 2004-05,despite some setbacks arising from aninsuff icient monsoon and sporadicsupply-side pressures on inflation. RealGDP growth at 6.9 per cent in 2004-05despite a sharp slowdown in agriculturepropelled average growth to 6.5 per centin the first three years of the Tenth FiveYear Plan period (2002-07). It exceeded,by a full percentage point, the averagereal GDP growth of 5.5 per cent achieved

* While the Reserve Bank of India’s accounting yearis July-June, data on a number of variables areavailable on a financial year basis, i.e., April-March, and hence, the data are analysed on thebasis of the financial year. Where available, the

data have been updated beyond March 2005. Forthe purpose of analysis and for providing properperspectives on policies, reference to past yearsas also prospective periods, wherever necessary,has been made in this Report.

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in the Ninth Plan period (1997-2002),while being broadly in line with theaverage of 6.7 per cent in the Eighth Planperiod (1992-97). Noteworthy features ofIndia’s macroeconomic performance in2004-05 include: first, the improvementin investment climate and pick-up inindustrial and service sector activity;second, emergence of buoyant exportsas a driver of demand in a large spectrumof industries; third, modest consolidationin the fiscal position; fourth, successfulmanagement of liquidity in the backdropof continuing capital flows; fifth, healthyinvestor confidence, as India receivedmore than a quarter of the global portfolioflows to emerging market economies(EMEs) in 2004 though India’s share inforeign direct investment continued to below at around 3 per cent; and finally,foreign exchange reserves reached US$ 141.5 billion at end-March 2005.

I.1.3 Underpinning the stronger thananticipated performance of the economyin 2004-05 was the quality and responseof macroeconomic management in theface of some adversity. In view of thepotential of destabilising pressures fromincreases in international fuel and othercommodity prices, and the shock to foodprices in the wake of the uneven South-West monsoon, policy coordinationinvolved a continuous rebalancing of theweights assigned to growth andmacroeconomic stability. A judicious mixof supply management, fiscal measuresto contain the pass-through of importedinflation and monetary policy action tostabilise inflationary expectations helpedin containing inflation from a mid-yearpeak of 8.7 per cent to 5.1 per cent bythe close of the year, consistent with theprojection given in the Annual PolicyStatement of the Reserve Bank in May2004. The Indian economy today is

characterised by an environment ofconfidence, posit ive businessexpectations, a renewal of rule-basedfiscal consolidation, stable and orderlyfinancial markets and institutions andprogressive integration with the globaleconomy.

I.1.4 It is in this context that this surveyof macroeconomic policy in 2004-05highlights the blending of real sectorpolicies designed to step up themomentum of growth with financialpolicies that ensure macroeconomic andfinancial stability. Concurrently, monetarypolicy operated as the anchor of theeconomy, ensuring liquidity, credit andinterest rate conditions conducive tomaintaining both growth and stability.Financial sector policies pursued thedevelopment and integration of financialmarkets and the soundness andefficiency of financial intermediaries thatoperate in an increasingly competitiveenvironment. Improvements in creditdelivery and customer satisfaction arethe challenges that have to be addressedfurther.

REAL SECTOR POLICIES

I.1.5 In 2004-05, several policyinitiatives were taken to strengthen themomentum of economic growth.Measures to boost agr iculturalproductivity were supported by policiesto expand the industrial base, especiallythrough greater investment ininfrastructure. In the context ofglobalisation of production systems,several init iat ives were aimed atpromoting exports, rationalising tradeduties and preparing the economy for thecommitments that may emerge from theDoha Round of the Wor ld TradeOrganisation (WTO).

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Agriculture and Allied Activities

I.1.6 The Government under tookseveral steps to expand the agriculturalproduction frontier through diversificationof production, spread of agriculturalmarketing, improvement of infrastructureincluding irr igation and extension ofagricultural research during 2004-05.These measures were suppor ted byparallel initiatives taken by the ReserveBank and the National Bank forAgr iculture and Rural Development(NABARD) to step up financing foragriculture. Several measures were alsoaimed at alleviating rural poverty.

I.1.7 In order to improve and expandirr igation faci l i t ies, the Fast TrackProgramme under the AcceleratedIrrigation Benefit Programme (AIBP) wasmodified in April 2004 to provide Centralassistance in the form of 70 per cent loanand 30 per cent grant for non-specialcategory States and 10 per cent loan and90 per cent grant for special categoryStates. For projects outside the FastTrack Programme, an incentive ofconversion of the loan to a grant is offeredif projects are completed on schedule.The outlay for the AIBP in the UnionBudget, 2005-06 was increased toRs.4,800 crore from Rs.2,800 crore in2004-05 to improve the pace ofimplementation.

I.1.8 A pi lot scheme for repair,renovation and restoration of waterbodies directly linked to agriculture isproposed to be taken up during theremaining period of the Tenth Plan. TheCommand Area and Water ManagementProgramme was restructured in April2004 to br ing about better watermanagement practices and efficientutilisation of irrigation water. The UnionBudget, 2005-06 has also envisaged a

national project for repair, renovation andrestoration of water bodies in 16 districtsin nine States covering about 20,000hectares of additional land. Recognisingthe importance of water harvesting, theDepar tment of Agr iculture and Co-operation has formulated a scheme forenhancing sustainabil ity of drylandrainfed farming with an allocation ofRs.200 crore for 2005-06. The schemeaims at addressing issues like rainwaterharvesting and its efficient utilisation, soilmoisture conservation, use of organicmanures and adoption of improveddryland farming technologies. Thescheme will be implemented in the aridand semi-arid regions of the country,par ticularly in the districts receivingannual rainfall less than 750 mm and withassured irrigation coverage less than 30per cent of the net sown area.

I.1.9 The Union Budget for 2005-06envisages that the Ministry of Agriculturewould prepare a roadmap for agriculturaldiversification focusing mainly on fruits,vegetables, f lowers, dairy, poultry,fisheries, pulses, oilseeds and otherallied activities in a planned manner. Anexpert committee was appointed by theGovernment to suggest improvements inthe price stabilisation fund to address thedifficulties of the plantation sector. TheUnion Budget, 2004-05 had proposed aNational Horticultural Mission with a viewto doubling horticultural production by2011-12. The Union Budget, 2005-06allocated Rs.630 crore to the NationalHorticultural Mission. Critical to thesuccess of the diversification programmeas well as that of the National HorticultureMission is the progress that States maketowards amending their State AgriculturalProduce Marketing Committee (APMC)Acts. While nine States and four UnionTerritories (UTs) have amended their

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APMC Acts, six States have initiatedpartial reforms.

I.1.10 The Government continued tostrengthen agricultural marketing reformsduring 2004-05. The Union Budget for2005-06 has allocated Rs.72 crore for anew scheme of development ofagricultural marketing with a view toinducing large investments from theprivate and the cooperative sectors forsetting up agricultural markets, marketinginfrastructure and support services suchas grading, standardisation and qualitycertification. This is also expected to givea boost to commodity futures markets asgrading and standardisation ofagricultural commodities would facilitatethe development of warehouse receipts.Several measures have been initiated todevelop commodity futures markets.There are, at present, three multi-commodity exchanges and 22 regionalexchanges in India.

I.1.11 In March, 2005 the Governmentapproved a scheme to support the Stateprogrammes for extension reforms. Theaim is to provide decentralised anddemand-driven extension system by wayof technology dissemination in the formof an Agr icultural TechnologyManagement Agency (ATMA) at thedistrict level.

I.1.12 The National Commission onFarmers was reconstituted in November2004 to address issues relating to acomprehensive medium-term strategy forfood and nutr i t ion secur ity. I t hasrecommended the establishment of RuralKnowledge Centres all over the countryusing modern information andcommunication technology. TheGovernment proposes to join Mission2007, a national initiative launched by anall iance compr ising near ly 80organisations including civil society

organisations, which plans to set up aknowledge centre in every village by2007, the 60th anniversary of India’sIndependence. The Government wouldroute its support through the NABARD.

I.1.13 In June, 2004 the Governmentlaunched a credit package to enhancethe flow of credit to agriculture, inconsultation with the Reserve Bank, theNABARD and commercial banks. TheUnion Budget, 2005-06 advisedcommercial banks (including RegionalRural Banks) and cooperative banks toincrease the flow of credit by another 30per cent. Public sector banks wereadvised to increase the number ofborrowers by another 5 million in 2005-06. The National Agricultural InsuranceScheme (NAIS), introduced in rabi 1999-2000, would be continued in its presentform for kharif and rabi 2005-06.

I.1.14 The Union Budget, 2005-06proposes to extend the coverage of theAntyodaya Anna Yojana from 20 millionBelow Poverty Line (BPL) families to 25million BPL families in 2005-06. Theallocation towards providing the cost offood grains for Mid-day Meal Schemewas increased to Rs.3,010 crore.

Manufacturing and Infrastructure

I.1.15 Macroeconomic measures takendur ing 2004-05 to boost industr ialproductivity were bolstered by sector-specific initiatives to raise foreign directinvestment (FDI), promote expor ts/Special Economic Zones (SEZs) andgear up to operating in a post-WTOenvironment.

I.1.16 The National Manufactur ingCompetitiveness Council (NMCC), set upin September 2004, provides a forum forpolicy dialogue to energise and sustainthe growth of manufacturing industries.

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A National Commission for Enterprisesin the Unorganised Sector, set up inSeptember 2004, acts as an advisorybody and a watchdog for the informalsector. The Investment Commission wasconstituted in February 2005 to facilitategreater inflow of FDI into the country. ANational Committee on RuralInfrastructure (NCRI), chaired by thePrime Minister, would initiate policies toensure time-bound provision of qualityinfrastructure in rural areas. In order toencourage sett ing up of units inknowledge-based industries such aspharmaceuticals, bio-technology andinformation technology, equity supportwould be provided through the Small andMedium Enterprises Growth Fund (SGF),which was launched in October 2004 bythe Small Industries Development Bankof India (SIDBI) jointly with major publicsector banks.

I.1.17 The National Electricity Policyannounced by the Government inFebruary 2005 aims at accelerateddevelopment of the power sector forproviding electricity to all areas andprotecting the interests of consumers andother stakeholders, keeping in viewavailabil i ty of energy resources,technology available to exploit theseresources, economies of generationusing different resources and energysecurity issues. Keeping pace with thetechnological advancements, theGovernment announced a BroadbandPolicy in October, 2004 with a view toproviding impetus to broadband andinternet penetration in the country.

I.1.18 The Government reviewed, inJanuary 2005, the guidelines notified videPress Note 18, which had stipulated itsapproval for new proposals for foreigninvestment/technical collaboration infields where the foreign investor has or

had any previous joint venture ortechnology transfer/trademarkagreement in India. In terms of therevised policy notified vide Press Note 1of 2005, pr ior approval of theGovernment would be required only incases where the foreign investor has anexisting joint venture or technologytransfer/trademark agreement in thesame field. Even in the same field, priorapproval wil l not be required ininvestments to be made by venturecapital funds, or if existing joint ventureinvestment by either of the parties is lessthan 3 per cent, or if the existing venture/collaboration is defunct or sick.

I.1.19 In February, 2005 the Governmentenhanced the composite foreign holdingin the telecommunication sector from 49per cent to 74 per cent in a host of basicservices such as international and nationallong distance services, basic telephoneservice, cellular mobile service and unifiedaccess service. With a view to catalysinginvestment, creating new employmentopportunities and adding to the housingand infrastructure stock, the Governmentallowed in March, 2005 FDI up to 100 percent under the automatic route intownships, housing, built-up infrastructureand construction-development projects,subject to some guidelines.

I.1.20 A new scheme to establish a FreeTrade and Warehousing Zone (FTWZ)was launched in December 2004 tocreate trade-related infrastructure tofacilitate the import and export of goodsand services with freedom to carry outtrade transactions in free currency, withbenefits as applicable for SEZ units. TheForeign Trade Policy in Apri l 2004proposed that an exclusive ServicesExport Promotion Council (SEPC) be setup in order to map opportunities for keyservices in main markets, and develop

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strategic market access programmes,including brand building in coordinationwith sectoral players and recognisednodal bodies of the services industry.

I.1.21 India introduced a new productpatents regime in March 2005 by approvingthe Patents (Amendment) Bill 2005covering drugs, foods and chemicals. Thiswas in compliance with the Trade-RelatedIntellectual Property Rights (TRIPS)agreement of the WTO. Stronger patentlaws are expected to encourage foreigninvestment in research and developmentprojects and benefit the Indian economy.

I.1.22 The Union Budget, 2005-06carries several measures to speed upindustrial growth such as dereservationof 108 items from the items exclusivelyreserved for the SSI sector and framingof a Manufacturing CompetitivenessProgramme to revive the manufacturingsector - particularly small and mediumenterprises - to enable it to adjust to thecompetit ive pressures caused byliberalisation and moderation of tariffrates. A 10 per cent capital subsidyscheme for the textile processing sectorwas announced in addition to the normalbenefits available under the TechnologyUpgradation Fund (TUF) Scheme.Financially viable infrastructure projectswould be funded through a SpecialPurpose Vehicle (SPV) covering projectsin roads, ports, airports and tourism.Finally, customs duties on a range ofproducts were reduced to bring the taxstructure closer to that of East Asianneighbours.

FISCAL POLICY

Central Government

I.1.23 The conduct of f iscal policyduring 2004-05 was shaped by the Fiscal

Responsibility and Budget Management(FRBM) Act, 2003 and FRBM Rules 2004(notified by the Central Government onJuly 5, 2004), which set a new beginningto the fiscal consolidation process. TheCentral Government planned sharperreductions in the revenue and the fiscaldeficits for 2004-05 than the minimumthresholds of the FRBM on expectationsof higher tax mobil isation andperseverance with prudent expendituremanagement.

I.1.24 Fiscal policy had to undertake amid-course realignment in 2004-05 in theform of post-Budget reduction in dutiesof petroleum products and non-alloy steelso as to mitigate imported supply-sidepressures on inflation. In order to remainon the path of fiscal consolidation, theGovernment under took measures toaccelerate recovery of tax arrears, boostnon-tax revenue and reduce low priorityexpenditure in the latter half of the year.The provisional accounts of 2004-05indicate that the fiscal deficit and theprimary deficit of the Central Governmentturned out to be lower than the revisedestimates. The Central Government wasable to achieve not only the FRBM targetsfor all the deficit indicators but also thebudget estimates in respect of the fiscaldeficit and the pr imary deficit. Therevenue deficit was, however, marginallyhigher than the budget estimate due tolower tax revenues than anticipated.Never theless, there has been asignificant improvement in the gross tax/GDP ratio from 8.8 per cent in 2002-03to 9.2 per cent in 2003-04 and further to9.9 per cent in 2004-05. A noteworthyfeature is a sustained rise in the directtax/GDP ratio to 4.3 per cent in 2004-05from around 2 per cent during the 1970sand 1980s and around 3 per cent in thelate 1990s.

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I.1.25 Tax reforms in 2004-05 focusedon streamlining of tax administration,recovery of tax arrears, widening of taxbase and provision of full tax rebate fortaxable income up to Rs. one lakhpending the revision of tax slabs andrates. The scope of the service tax waswidened and excise duties wererationalised, especially in preparation forthe introduction of Value Added Tax(VAT).

I.1.26 Guidelines on ExpenditureManagement – Fiscal Prudence andAusterity were issued on October 1,2004. The Guidelines stipulate, inter alia,a scrutiny of all on-going programmesand schemes, a 10 per cent cut inbudgetary allocations under non-Planand non-salary expenditure and that allprofit making public sector undertakingsdeclare a minimum dividend of 20 percent. The Government also reiterated itscommitment to utilise only 33 per cent ofbudgeted expenditure in the last quarterof the financial year. Improved cashmanagement practices introduced in2003-04 in nine high spendingdepartments/ministries were carr iedforward during 2004-05.

I.1.27 The Union Budget for 2005-06 iscommitted to tax reforms, employment-oriented economic growth, strengtheningthe social and rural infrastructure,cooperative f iscal federalism andemphasis on realisation of outcomesfrom the proposed expenditures. Theneed to earmark higher transfers to theState Governments under taxes andgrants as recommended by the TwelfthFinance Commission (TFC), the need tomake provision for compensating Statesfor any revenue loss that may result fromthe implementation of VAT anddiscontinuation of the practice of treatingdisinvestment proceeds as a budgetary

source of funds necessitated a ‘pause’in the FRBM path during 2005-06.

Tax Reforms

I.1.28 The Union Budget, 2005-06 hassimplified and rationalised direct taxes.On the personal income tax, measuresinclude raising the exemption limit up toRs. one lakh; reducing the effective taxrates through scaling up of tax brackets(i.e., 10 per cent for income between Rs.1lakh and Rs.1.5 lakh, 20 per cent forincome between Rs.1.5 lakh and Rs.2.5lakh and 30 per cent for income aboveRs.2.5 lakh); and removal of sectoralcaps in tax savings to al low for aconsolidated limit of Rs. one lakh. Thethreshold exemption levels for womenand senior citizens were fixed higher atRs 1.35 lakh and Rs 1.85 lakh,respectively. The level of taxable incomeat which the surcharge of 10 per centwould apply has been raised to Rs.10lakh. These measures would increasedisposable income and give taxpayersflexibility in planning their saving andinvestment. The corporate tax rate wasreduced to 30 per cent from 35 per cent,though the surcharge was increased from2.5 per cent to 10 per cent. Thewithholding tax on technical services wasreduced from 20 per cent to 10 per centso as to encourage technologicalupgradation.

I.1.29 Two new taxes have beenintroduced viz., the banking cashtransaction tax (BCTT) and the fringebenefit tax (FBT). The BCTT wasproposed to be levied at the rate of 0.1per cent on cash withdrawals of overRs.10,000 or more on a single day frombanks to establish a trail to check taxevasion. The BCTT was, however,subsequently made applicable to cashwithdrawals of Rs.25,000 and above in

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respect of individuals and Rs. one lakhand above for corporates from accountsother than savings accounts. The FBTwas introduced to tax perquisites(excluding transpor t and canteenservices) that are enjoyed collectively byemployees and cannot be collectedindividually, and hence were escaping thetax net. The rates of securities transactiontax (STT) on various transactions wereraised marginally.

I.1.30 On indirect taxes, the peak rateof customs duty on non-agriculturalimports was reduced from 20 per cent to15 per cent with a few exceptions.Customs duties on select capital goodsand parts thereof were also reduced. Inorder to expand the coverage of goodsunder the Central Value Added Tax(CENVAT) rate of 16 per cent, three outof the five items – polyester filament yarn,tyres and air conditioners – were movedfrom the 24 per cent level to the CENVATrate of 16 per cent. Excise duties wereabolished on liquefied petroleum gas(LPG) for domestic consumption and onsubsidised kerosene. The excise duty onother petroleum products, includingpetrol and diesel, has been fixed as acombination of ad valorem and specificduties. The service tax net was expandedto include nine additional services whileretaining the tax rate at 10 per cent. Smallservice providers with gross turnover notexceeding Rs. four lakh per annum wereexempted from service tax.

Expenditure Management

I.1.31 The Union Budget, 2005-06 hasemphasised the need to reorientexpenditure whereby performance ismonitored in terms of outcomes ratherthan outlays. With a view to enhancingthe effectiveness of implementation of

various programmes, greater flexibility isaccorded to ministries/departments inmanaging their departmental budgetswith concomitant incentives anddisincentives. To enhance transparencyand accountability, ministries would berequired to disseminate informationregarding their expenditure and receiptsto the general public on a frequent basis.Subsidies would be restructured andproperly targeted so that the benefits arenot usurped by those for whom they arenot intended. The user charges would bereviewed to increase non-tax revenueand reduce the operational losses ofcommercial undertakings. In consonancewith announcements in the Budget, theCentral Government would be releasingan outcome budget which would specifythe desired outcomes in quantitativeterms with a time frame for achievingthem.

State Governments

I.1.32 The policy framework for theState Governments in 2004-05 wasshaped by three signif icantdevelopments, viz., (i) the on-going fiscaland institutional reforms at the Statelevel, facilitated and supplemented byinitiatives of the Central Government andthe Reserve Bank; ( i i) the generalacceptance of the recommendations ofthe TFC which would form the basis offederal fiscal relations over the five-yearperiod beginning 2005-06; and (iii) theimplementation of the VAT by a numberof States with effect from April 1, 2005.

I.1.33 The Report of the Working Groupof select State Finance Secretaries anda representative of the CentralGovernment, constituted to frame amodel fiscal responsibility legislation(FRL) at the State level, was finalised inJanuary 2005 and subsequently placed

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in the public domain. It provides aframework for FRL and leaves it to thediscretion of the States to work out thespecif ics in respect of var iousparameters. Manipur, Chhattisgarh andTripura presented their FRL Bills whileAndhra Pradesh promulgated anordinance in this regard. Twelve States(Karnataka, Kerala, Punjab, Tamil Nadu,Uttar Pradesh, Or issa, Rajasthan,Maharashtra, Assam, Gujarat, HimachalPradesh and Haryana) have alreadyenacted their FRLs. Meghalaya, MadhyaPradesh and Uttaranchal have proposedFRL in their budgets for 2005-06.

I.1.34 The TFC Repor t tabled inParliament in February 2005 contains theblueprint of fiscal federalism over themedium term. A larger amount oftransfers than in the past has beenconsidered so as to reverse the declinein the volume of transfers relative to GDPand to ensure minimum vertical transfers(between Centre and States) whilecorrecting a larger horizontal imbalance(among States). Total resource transfersfrom the Centre to the States (comprisingshareable tax revenue and grants) havebeen placed at Rs.7,55,752 crore for theperiod 2005-06 to 2009-10, nearly 74 percent higher than for the period 2000-01to 2004-05 recommended by theEleventh Finance Commission.

I.1.35 The State Budgets for 2005-06continued to place emphasis on fiscalconsolidation through cur tailment ofunwarranted expenditure. Some StateGovernments have proposed to modify,if not revoke, the policy of providing freepower to some sections of society. SomeStates have implemented ContributoryPension Funds in order to address theirlarge pension obligations. Initiatives toclear the arrears of defaulting publicsector undertakings as well as according

high priority to power sector reforms werealso evident in the State budgets.

I.1.36 An important achievement in thearena of tax reforms is theimplementation of VAT by 20 StateGovernments with effect from April 1,2005 following the release of a WhitePaper on the subject by the EmpoweredCommittee of State Finance Ministers.Avoidance of the cascading effects oftaxation and the promotion of taxcompliance through a system of self-assessment, which are intrinsic to theVAT, would not only lead to enhancedeconomic efficiency but also to revenuebuoyancy over a period of time. TheUnion Budget for 2005-06 includes aprovision of Rs.5,000 crore ascompensation to the States on accountof shortfall in revenue that may arise dueto implementation of State-level VAT. Amajor issue which the EmpoweredCommittee would revisit during 2005-06relates to the phasing out of the inter-State or Central Sales Tax (CST). TheStates mobilise around Rs.15,000 croreof revenue annually from this source.

EXTERNAL SECTOR POLICIES

I.1.37 The dynamics of global trade andthe opportunities provided by bilateraland multilateral trading platforms havenecessitated a continuous realignment ofIndia’s international trade strategies andpriorities. In this regard, a comprehensiveForeign Trade Policy 2004-09 (FTP 2004)was announced on August 31, 2004. Thebasic objective of the policy is to doubleIndia’s share of global merchandise tradeby 2009 and to make exports an effectiveinstrument of economic growth andemployment generation. The keystrategies adopted in the FTP to enhanceexpor ts include faci l i tat ing thedevelopment of India as a global hub for

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manufacturing, trading and services;identifying and nurturing special focusareas l ike agr iculture, handlooms,handicraft, gems and jewellery, leatherand footwear, and mar ine sectors;simplification of procedures; reduction intransaction costs; and neutralisation ofincidence of all levies and duties oninputs used for expor ts. In addition,expor t promotion schemes such as‘Vishesh Krishi Upaj Yojna’ and ‘Servedfrom India’ were also announced toaccelerate the growth of agricultural andservice exports. FTP 2004 also revampsand revitalises the Board of Trade toadvise the Government on policymeasures for preparation andimplementation of short-term and long-term plans for increasing exports.

I.1.38 In February, 2005 certain ‘thrustareas’ were identified for policyimplementation during 2005. Theseincluded the introduction of Electronic DataInterchange (EDI) with regard to foreigntrade for online filing and data collection;implementation of the Report of the TaskForce on Project Exports; shaping of thecontents of SEZ and CompetitiveEconomic Zone Policy, including theCentral SEZ Act, to enable world classinfrastructure through private participationand a hassle-free regulatory regime invarious areas including taxation, customsand labour, in the SEZs; and institutionalreform in terms of decentralisation,simplification, transparency, accountabilityand e-governance.

I.1.39 The FTP was backed by anumber of measures to accord greaterflexibility to exporters in their foreignexchange transactions. Exporters wereallowed to approach banks to open/hirewarehouses abroad initially for one yearon a renewal basis. Payments in foreigncurrency were al lowed by units in

domestic tariff areas (DTAs) towardsgoods supplied to them by units in SEZsand by project/service exporters to theirIndian suppliers/ service providers.Realisation of export proceeds up to 360days from the date of shipment wasallowed for expor t of goods on aconsignment basis. Exporters, includingthose in small and medium sectors, withgood track record were made eligible forthe Gold Card scheme for easyavailability of export credit.

I.1.40 The FTP was fine-tuned in April2005. The Policy provides a package ofincentives and promotional measures foragriculture, marine products, expor toriented units and service sectors. Itenvisages major procedural simplificationto reduce transaction costs and thesetting up of an Inter-State Trade Councilto engage State Governments moreactively in the expor t effor t. It alsoproposes to abolish cess on export of allagricultural and plantation commoditieslevied under the various CommodityBoard Acts. In order to give a boost toagricultural exports, benefits under theVishesh Krishi Upaj Yojana have beenextended to poultry and dairy productsin addition to flowers, fruits, vegetables,minor forest produce and value addedproducts.

I.1.41 Importers have been accordedgreater f lexibi l i ty in transactions.Documentation for import remittancesmade into India has to be provided onlyfor amounts above US $ 100,000. Thelimit for accepting exchange control (EC)copy of bill of entry for import remittanceswas also enhanced to US $ one millionon a selective basis. Credit for importsup to US $ 20 million per transaction witha maturity period beyond one year andup to three years was permitted for importof capital goods. Limit for direct receipt

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of impor t bi l ls/documents by non-corporate importers was raised to US $100,000 or its equivalent.

Management of Foreign ExchangeTransactions

I.1.42 Several measures wereundertaken by the Reserve Bank toliberalise foreign exchange transactionsby residents dur ing 2004-05. Thecondition that shares should be offeredat a concessional price for the acquisitionof foreign securities by residents underthe Employees Stock Option Plan(ESOP) was dispensed with. Sharesacquired under the ESOP were allowedto be sold without obtaining pr iorpermission of the Reserve Bank,provided the proceeds thereof arerepatriated to India.

I.1.43 With a view to promoting Indianinvestments overseas, the ceiling onoverseas investment by Indian entitieswas raised from 100 per cent to 200 percent of their net wor th under theautomatic route. Corporates weregranted general permission forconversion of the ECBs into equity withthe exception of import payables deemedas ECBs and subject to prescr ibedrepor ting requirements. Generalpermission was also granted for transferof shares and convertible debentures(excluding financial services sector)subject to compliance with the terms andconditions and reporting requirements fortransfer by a person resident in India toa person resident outside India and viceversa.

MONETARY POLICY FRAMEWORK

I.1.44 The monetary policy stance for2004-05 was conditioned by expectationsof a normal monsoon, sustained growth

in industry and expor ts, and theassumption of no significant supplyshocks. The Reserve Bank’s AnnualPolicy Statement for 2004-05 recognisedthat international interest rates werehardening, international crude priceswould remain elevated and volatile andcapital inflows would persist. Consistentwith the expectation of real GDP growthof 6.5 to 7 per cent, inflation at 5 per cent,non-food credit growth (adjusted) at 16to 16.5 per cent and the Centre’sborrowing programme within a fiscaldeficit of 4.4 per cent of GDP, the overallstance of monetary policy for 2004-05was stated as:

• Provision of adequate liquidity to meetcredit growth and support investmentand export demand in the economywhile keeping a very close watch onthe movements in the price level.

• Consistent with the above, whilecontinuing with the status quo, topursue an interest rate environmentthat is conducive to maintaining themomentum of growth andmacroeconomic and price stability.

I.1.45 Dur ing the year, however,monetary management faced severechallenges, warranting a re-balancing ofobjectives in the context of underlyingdevelopments. The risks to stability beingperceived as high from thesedevelopments, monetary policymeasures were under taken in acalibrated manner during the year. Evenas the inflation projection was raised toaround 6.5 per cent in the Mid-termReview October 2004, the Reserve Bankintensif ied the monitor ing of pr icemovements, switching its stance from a‘very close watch on the movements inthe price level’ in the Annual PolicyStatement to ‘equal emphasis on pricestability’ in the Mid-term Review. Similarly,

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the objective of liquidity managementwas changed from a provision of‘adequate l iquidity’ to ‘appropriateliquidity’.

I.1.46 The Reserve Bank’s AnnualPolicy Statement of April 2005 stated thatthe stance of monetary policy woulddepend on several factors, includingmacroeconomic prospects, globaldevelopments and the balance of risks.Assuming a normal monsoon, andbarring the emergence of any adverseand unexpected developments in varioussectors of the economy and keeping inview the inflationary situation, the overallstance of monetary policy for the year2005-06 would continue to be as set outin the Mid-term Review of October 2004.

I.1.47 In its First Quarter Review of theAnnual Statement on Monetary Policy(July 26, 2005), the Reserve Bankindicated that its current assessment ofmacroeconomic outlook and the overallstance remains broadly unchanged.

Credit Delivery System

I.1.48 The Reserve Bank intensifiedefforts to improve the credit deliverysystem with a view to stepping up creditto agriculture and small and mediumenterprises. As a multi-pronged strategyfor facilitating credit to the priority sector,the number of categories of advancesunder the ambit of the priority sectorlending was enlarged and limits on loansunder the priority sector were enhanced.Banks were allowed to advance loans todistressed urban poor to prepay theirdebt to non-institutional lenders againstappropriate collateral or group securityand classify the same under weakersections within the priority sector.

I.1.49 Banks were advised to makeefforts to increase their disbursements to

small and marginal farmers to 40 per centof their direct advances under specialagricultural credit plans (SACPs) byMarch 2007. In view of the Union FinanceMinister’s announcement in June 2004for doubling the f low of credit toagriculture in the next three years, privatesector banks were advised to fix theSACP target for the year 2005-06showing a growth rate of 30 per cent overdisbursements during the year 2004-05.Banks were allowed to waive margin/security requirements for agriculturalloans up to Rs.50,000 and in the case ofagri-business and agri-clinics for loans upto Rs five lakh. Interest rates on the RuralInfrastructure Development Fund (RIDF)were revised downwards in alignmentwith the softening of the interest ratestructure over the years.

I.1.50 Several initiatives were alsotaken to facilitate the development ofmicro-finance. The NABARD revised theModel Kisan Credit Card (KCC) schemewith a view to providing thecomprehensive credit requirements offarmers - covering term credit, workingcapital for agriculture and allied activitiesand a reasonable component forconsumption needs - under a singlewindow in a timely manner.

FINANCIAL SECTOR POLICIES

I.1.51 The thrust of the Reserve Bank’sfinancial sector policies continued to beon strengthening the health of financialinstitutions as well as on improving theefficiency of financial markets. Policyinitiatives encompassed the adoption ofinternational standards and codes in thebanking system, strengthening urbancooperative banks (UCBs) and non-banking financial companies (NBFCs)and improvement in customer services.The Reserve Bank undertook several

13

init iat ives to improve corporategovernance in the banking system. TheIndian banking system became fullycompliant with Basel I standards byMarch 2005.

I.1.52 The Reserve Bank intensified itsefforts to ensure that UCBs emerge as asound and healthy network of jointlyowned, democratically controlled andethically managed banking institutionsproviding need-based quality bankingservices essentially to the middle andlower middle classes and marginalisedsections of the society. The Reserve Bankcontinued to take policy initiatives with aview to developing NBFCs as financiallystrong entities.

I.1.53 The Reserve Bank continued tostress the need to improve customerservices by banks to ensure that thebenefits of f inancial l iberal isationpercolate to the widest sections ofsociety. Several measures wereunder taken on the basis of therecommendations of the Committee onProcedures and Performance Audit onPublic Services (Chairman: Shri S. S.Tarapore).

Policies for Financial Markets

I.1.54 During 2004-05, the ReserveBank undertook several initiatives to furtherimprove the functioning of the money, thedebt and the foreign exchange markets.Internal technical groups on the moneymarket, the Government securities marketand the foreign exchange market were setup to chart a medium-term framework forthe future course of market developmentin the context of the ongoing changes inthe institutional framework and marketdynamics.

I.1.55 In the capital market, policyinitiatives were directed towards further

broadening and deepening the markets,achieving better investor protection andmaking the market investor friendly. In thepr imary market, the share of retailinvestors’ in the public issues was raisedfrom the existing 25 per cent to 35 percent. The scope of retail investment wasscaled up to Rs. one lakh from the earlierlimit of Rs.50,000. In order to make theissue process user-friendly, disclosuresin issue prospectus were simplified andpresentation was made uniform. Stepswere also taken for shor tening theallotment period for the new issues. Inthe secondary market, a comprehensiverisk management framework for the cashsegment was introduced to keep pacewith the dynamic state of the markets.Risk containment measures and positionlimits in the equity derivatives were alsomodified.

I.1.56 In order to strengthen thecorporate governance practices for thelisted companies, the Securities andExchange Board of India (SEBI) revisedthe existing Clause 49 of the listingagreement to introduce signif icantchanges in areas such as compositionof the board of directors, audit committee,report on corporate governance andcompliance with the norms. The revisedcode comes into effect from January 1,2006. The listing of all debt securitiesirrespective of the mode of issuance (i.e.,whether issued on private placementbasis or through public/rights issue) is tobe done through a separate l istingagreement.

I.1.57 The Union Budget Speech, 2005-06 laid strong emphasis on strengtheningthe Indian capital market. With a view todeveloping the corporate bond market,a high-level exper t committee oncorporate bonds and securitisation wasproposed to examine legal, regulatory,

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tax and market design issues. Thedefinit ion of ‘secur it ies’ would beamended under the Securities Contracts(Regulation) Act, 1956 so as to providea legal framework for trading ofsecuritised debt, including mortgage-backed debt. It was also decided to allowFIIs to submit appropriate collateral, incash or otherwise, as prescribed by theSEBI, while trading in derivatives in thedomestic market.

I.1.58 The Union Budget, 2005-06envisages the provision of legal validityfor over-the-counter (OTC) derivativecontracts. Mutual funds would be allowedto introduce Gold Exchange TradedFunds (GETFs) in consultation with theReserve Bank. To make Mumbai aregional hub for finance, a high-poweredexpert committee is proposed to be setup in consultation with the Reserve Bankto advise the Government.

Changes in the Legal Framework

I.1.59 Several significant initiativeswere undertaken in 2004-05 towardsimproving the legal infrastructure. TheEnforcement of Security Interest andRecovery of Debt Laws (Amendment)Act, 2004 amended the Securitisationand Reconstruction of Financial Assetsand Enforcement of Security Interest Act,2002 (SARFAESI), the Recovery ofDebts Due to Banks and FinancialInstitutions Act, 1993 and the CompaniesAct, 1956. The Banking Regulation(Amendment) and MiscellaneousProvisions Act, 2004 came into force inSeptember 2004. The Credit InformationCompanies (Regulation) Act, 2005requires companies in the business ofcredit information to obtain a certificateof registration from the Reserve Bank.

I.1.60 A number of key reform bills wereintroduced in the Par l iament. The

Government Secur it ies Bil l , 2004introduced in the Lok Sabha in December2004 proposes to consolidate and amendthe laws relating to the Governmentsecurities and its management by theReserve Bank.

I.1.61 The Reserve Bank of India(Amendment) Bill, 2005 seeks to amendthe Reserve Bank of India Act, 1934 todefine the expressions ‘derivative’, ‘repo’and ‘reverse repo’. The Reserve Bankwould be empowered to deal inderivatives, to lend or borrow securitiesand to undertake repos or reverse repos.The lower floor and upper ceiling on thecash reserve ratio (CRR) would beremoved to provide the flexibility to theReserve Bank to specify the CRR. Theambiguity regarding the legal validity ofOTC derivative products is also beingaddressed through amendment to theReserve Bank of India Act. The ReserveBank would be empowered to lay downpolicy and issue directions to any agencydealing in various kinds of contracts inrespect of Government securities, moneymarket instruments and derivatives andto inspect such agencies.

I.1.62 Although there is no specificrestriction in the Banking RegulationAct on acquisition of shares in a bankingcompany, no person can at presentexercise voting right in excess of 10 percent of the total voting rights of all theshare holders. The Banking Regulation(Amendment) Bill, 2005 seeks to amendthe Banking Regulation Act, 1949 toinclude provisions for removing therestriction on voting rights concurrentlywith the stipulation of the statutoryrequirement of pr ior approval foracquisition of shares above five per centof the voting rights in banking companies.The Reserve Bank would now beaccorded the power to specify Statutory

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Liquidity Ratio (SLR) without any floor,subject to the existing ceiling of 40 percent of total demand and time liabilities.It may also specify any security as anapproved security for this purpose. TheReserve Bank would have the right to callfor information and returns from theassociate enterpr ises of bankingcompanies also and inspect them, ifnecessary. It would have the authority tosupersede the board of directors of abank and appoint an administrator tomanage the bank t i l l alternativearrangements are made. Finally, theReserve Bank would also be vested withthe powers to order a special audit of co-operative banks in the public interest.

II. THE REAL ECONOMY

I.2.1 Setbacks from an uneven anddeficient South-West monsoon and highinternational crude oil prices in 2004-05tempered the robust resurgence ofgrowth that had been achieved in thepreceding year. Although real GDPgrowth slowed to 6.9 per cent in relationto the 8.5 per cent in 2003-04, the overallmacroeconomic performance wasimpressive during 2004-05. Indiaremained one of the fastest growingemerging market economies. The growthof real GDP originating in agriculture andallied activities in 2004-05 turned out tobe more resilient than anticipated and acertain degree of insulation from weathershocks seems to have set in. The firmingup and spread of the upturn in industrialactivity led by manufactur ing wassuppor ted by a positive investmentcl imate, business confidence andbuoyant external demand. Financialperformance of the corporate sector wasrobust during the year. However, it wasthe services sector that anchored thegrowth process dur ing the year,

contributing as much as 70.5 per cent tothe real GDP growth in 2004-05. Trade,transportation, communication, businessand financial services, software servicesincluding Information TechnologyEnabled Services (ITES)-BusinessProcess Outsourcing (BPO) were thekey movers of services sector growth in2004-05.

Agriculture

I.2.2 Growth of real GDP originatingfrom ‘agriculture and allied activities’decelerated sharply to 1.1 per cent during2004-05 from 9.6 per cent a year ago.This was essentially the outcome of theuneven and deficient South-Westmonsoon besides the base effect of thehigh growth of 2003-04. During 2004, theSouth-West monsoon turned erratic withan unusual warming of sea surfacetemperatures over the Equatorial CentralPacif ic region leading, in turn, toprolonged weakness/break in themonsoon over different parts of India.

I.2.3 According to the Fourth AdvanceEstimates released by the Ministry ofAgr iculture on July 6, 2005, khariffoodgrains production is estimated ataround 103 million tonnes during 2004-05 - a shortfall of around 12 per cent fromthe preceding year. The decline infoodgrains production emanated mainlyfrom the slippage in the production ofcoarse cereals and rice. Kharif oilseedsalso recorded a shortfall of around 11 percent. Rabi production recouped some ofthe loss in khar if output. The rabifoodgrains production is estimated atover 101 million tonnes, exceeding theprevious year’s level (around 97 milliontonnes). The rabi output of r ice andcourse cereals is expected to have scaleda new peak. Rabi oilseeds production isalso expected to have exhibited a sharp

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rebound (31 per cent). Consequently, thetotal foodgrains production during 2004-05 is estimated at around 205 milliontonnes, about four per cent lower than inthe preceding year. Among the cashcrops, the production of cotton andoilseeds is expected to have scaled anew high. The output of sugarcane is,however, expected to have suffered somelosses. Overall, the index of agriculturalproduction during 2004-05 is expected tohave registered a decline of 1.2 per cent.

I.2.4 As against the forecast of anormal monsoon by the IndiaMeteorological Department (IMD), thecumulative area-weighted rainfall duringthe South-West monsoon season (June1 to September 30) 2004 turned out tobe 13 per cent below the Long PeriodAverage (LPA) as against two per centabove the LPA during the previous year.Notwithstanding an early onset, themonsoon came to a halt for a fairly longduration during the critical sowing months(June and July). The rainfall was alsounevenly distributed with 23 out of 36meteorological sub-divisions recordingnormal rainfall and 13 receiving deficientrainfall.

I.2.5 The total stocks of foodgrains withthe Food Corporation of India (FCI) andthe State agencies stood at around 25.1million tonnes as on July 1, 2005, around18.0 per cent lower than a year ago.

Industrial Performance

I.2.6 Real GDP growth originating fromindustry rose to 8.3 per cent - the highestgrowth after 1995-96 - as the industrialrecovery spread out and strengthenedduring 2004-05. Industrial activity waspowered by the manufacturing sector. Acongenial domestic investment climate,improvement in world output, a liberalised

foreign direct investment (FDI) regime andsurging manufacturing exports supportedthe buoyant performance of themanufactur ing sector. Lower debtservicing costs also facilitated the strongperformance of the manufacturing sector.Intensified competition has encouraged aprocess of consolidation and restructuringof the Indian industry in tune with globalsupply and demand conditions asintegration with the global productiongathers pace.

I.2.7 Growth in the Index of IndustrialProduction (IIP) accelerated from 7.0 percent during 2003-04 to 8.2 per cent during2004-05, led by the manufacturing sector.The output of the electr icity sectorregistered a marginal improvement duringthe year - both thermal and hydro powerplants recorded better performance. Themining sector performed well in the firsthalf of the year, but subsequently lostmomentum due to slowdown in productionin some of the subsidiary companies ofCoal India Limited.

I.2.8 The manufactur ing sectorrecorded a growth of 9.0 per cent during2004-05. Machinery and equipment andchemicals and chemical products largelyled this robust growth. In terms of the two-digit classification, 15 out of 17 industrygroups logged positive growth during theyear as compared with 12 groups duringthe previous year. Cotton textiles, juteand other vegetable fibre textiles (exceptcotton), texti le products ( includingwearing apparels) and leather and furproducts made a turnaround during2004-05. The improved performance oftexti le industry was largely led bydomestic demand while expor tsdisplayed a mixed trend.

I.2.9 One of the outstanding featuresof industrial activity during 2004-05 wasthe strong growth of the capital goods

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sector. Machinery and equipment ledrobust growth of the capital goods sector.Expanding investment activity driven byboth domestic and external demand wasreflected in higher capital expenditureand capital goods imports, leading toincrease in capacity creation across awide spectrum of industr ies. Non-electr ical machinery contr ibutedsubstantially to the growth of capitalgoods imports. The imports of othercapital goods such as professionalinstruments, optical goods, electricalmachinery, machine tools and projectgoods also increased signif icantly.Current trends in corporate financessuggest that Indian industry appears tobe embarking on a new investment cycle.

I.2.10 The infrastructure sectorcontinued to remain subdued during2004-05, mainly on account ofdeceleration in output of finished steel,coal and petroleum refinery products. Thegrowth of the core infrastructureindustries decelerated to 4.4 per centfrom 6.2 per cent in 2003-04.Deceleration in production of coalcoupled with constraints in coalmovement led to subdued electricitygeneration and cement production duringthe last quarter of the year, draggingdown the overall infrastructure growth.Electricity generation, however, recordeda marginal pick-up in growth on accountof higher power generation in hydro andthermal power plants during the first halfof the year coupled with higher plant loadfactor of 74.8 per cent in respect ofthermal power plants. The production ofcrude petroleum remained subdued onaccount of poor performance of private/joint venture units. The shut-down ofsome refineries impacted the productionof petroleum refinery products. Duringthe year, the f inished steel sector

recorded lacklustre growth mainly due tosupply constraints on inputs such as ironore, scrapped iron and coking coal.

I.2.11 During 2004-05, there was asubstantial growth of 75.5 per cent in thevalue of acquisitions in the industrialsector. Mergers and acquisitions (M&As)were concentrated mainly in sectors likechemicals, non-metall ic mineralproducts, computer software and mining.The telecommunications sector entereda consolidation phase with smallerplayers selling out to the larger ones. Thehigh growth and steady revenue streamsin the Information Technology EnabledServices (ITES) have also led to anincrease in M&As.

I.2.12 The overall investment climateduring 2004-05 was buoyant as reflectedin the investment intentions registered inIndustrial Entrepreneurs Memoranda(IEMs) and Letters of Intent (LOI), andin the implementation of IEMs. Asignif icant investment revival issuggested by the very substantialincrease in investment intentionsregistered in 2003-04 which fur thernearly doubled in 2004-05.

I.2.13 Small scale industries (SSIs)continue to play a significant role inindustrial activity. The share of SSIs inthe gross industrial value added in theeconomy is around 40 per cent. About44 per cent of total manufactured exportsare directly accounted for by the SSIsector.

I.2.14 During the first quarter of 2005-06, industrial production accelerated to10.3 per cent on the back of a markedpick-up in growth in manufacturing andelectricity sectors to 11.2 per cent and7.6 per cent, respectively. Anencouraging development in themanufacturing sector was the turnaround

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in food products, after a deceleration ingrowth in the past two years. The growthin the mining sector, however,decelerated to 4.5 per cent. According tothe use-based classification, the capitalgoods sector maintained high growthsupported by strong performance ofmachinery and equipment, transportequipments and commercial vehicles.The consumer goods recorded a double-digit growth on the back of strongperformance of both durable and non-durable segments. Basic goods alsorecorded higher growth during the firstquar ter. Intermediate goods sector,however, slowed down significantly, interalia, due to a decline in production ofpetroleum products. The overall growthof core infrastructure industries duringthe first quarter of 2005-06 was lower at5.5 per cent than 8.1 per cent during thecorresponding per iod of 2004-05although there are signs of a pick up. Theslowdown was mainly a reflection ofdecline in crude petroleum and petroleumrefinery production and deceleration infinished steel during April and May 2005.

I.2.15 The NCAER BusinessConfidence Index (BCI) stood at 144.1 forJuly 2005 which is the highest levelattained since December 1995. Accordingto the Reserve Bank’s Industrial OutlookSurvey, the Business Expectations Indexfor July-September 2005 stood at 119.6points, registering a decline of 1.1 per centover the previous quarter. The Dun &Bradstreet’s Composite BusinessOptimism Index for the second quarter of2005-06 recorded an increase of 5.6 percent over the previous quarter.

Services Sector

I.2.16 The services sector remained thekey driving force of the economy in 2004-05. The growth of the services sector at

8.6 per cent was higher than the averagegrowth of 7.5 per cent during the last fiveyears. The services sector’s contributionto GDP growth has been more than 50 percent since 1997-98. The share of theservices sector in the GDP at 57.6 per centin 2004-05 was higher than in otherdeveloping countries as a group. Therobust performance of the services sectorduring 2004-05 was led mainly by ‘trade,hotels, transport and communication’,which contributed around 60 per cent ofthe sector’s growth. The strong growth inthe trade sector was on account of surgein exports and imports during the year.Activity in the hotel industry improvedsignificantly, aided by a recovery in tourism,particularly in business and leisure travel.

I.2.17 The most visible dimension of thesustained growth in the services sectorhas been the contribution of the softwaresector, including ITES and BPOsegments. According to the NationalAssociation of Software and ServicesCompanies (NASSCOM), the totalrevenues (exports as well as domestic)of the Indian IT-ITES industry grew by 32per cent to US $ 22 billion during 2004-05, constituting 3.0 per cent of GDP. Thiswas on account of rapid growth in demandfrom overseas and domestic consumers,backed by technological advancementand proactive policy reforms such asderegulation, privatisation, opening up toFDI and generous tax incentives for thesector. In addition to revenue earnings,employment in the IT-ITES sectorincreased exponentially from 280,000people in 1999-2000 to 1.05 million peoplein 2004-05 - a compound annual growthrate of 29.8 per cent.

AGGREGATE DEMAND

I.2.18 Information on the constituents ofaggregate demand is available only up

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to 2003-04 from the Central StatisticalOrganisation (CSO). A strong pick-up inreal pr ivate consumption demand in2003-04 was accompanied by a rise inGovernment demand - consumption aswell as investment. In particular, publicinvestment registered a sharpacceleration, whereas private investmentexper ienced deceleration fromexceptionally high growth in 2002-03.

I.2.19 The rate of Gross DomesticSaving (GDS), as a proportion to GDP atcurrent market pr ices, increasedsubstantially from 26.1 per cent in 2002-03 to 28.1 per cent in 2003-04, reflectingimprovement across all the sectors. Thehousehold sector continued to be the majorcontributor to GDS with its saving rateplaced at 24.3 per cent in 2003-04 ascompared with 23.3 per cent in 2002-03.Since 2000-01, the household sector hasshown a preference for saving in the formof physical assets relative to financialassets. This could be attributed partly tothe soft interest rate regime in recent years.Private corporate saving, which has beenincreasing steadily since 2001-02reflecting strong growth in profits, stood at4.1 per cent in 2003-04. The rate of dis-saving of the public sector continued todecline and contracted to 0.3 per cent in2003-04 from 1.1 per cent in 2002-03 onaccount of significant improvement in theperformance of public authorities.

I.2.20 Preliminary estimates, based onthe latest available information, place therate of financial saving (net) of thehousehold sector in 2004-05 at 9.9 percent of GDP at current market prices ascompared with the revised estimates of11.4 per cent in 2003-04. Increases in therate of saving in the form of claims onGovernment (particularly, small savings)and investment in shares and debentureswere more than offset by decline in

saving in the form of currency, depositsand contractual saving. Financiall iabi l i t ies of the household sectorregistered a sharp increase due to higherloans and advances principally driven bypersonal loans to finance consumerdurables and increased demand forhousing loans.

III. MONEY, CREDIT AND PRICES

I.3.1 The evolution of monetaryconditions during 2004-05 reflected theimpact of a number of developments.First, capital flows continued to be strong,despite a lull during May-October, 2004and l iquidity condit ions, given theoverhang of over Rs.81,000 crore at thebeginning of the year, remained easy.With the persistence of capital flows, theReserve Bank continued with sterilisationoperations through the LiquidityAdjustment Facility (LAF) and the newly-introduced Market Stabilisation Scheme(MSS), which contained money supplywithin the indicative projection set in May,2004. Second, there was a robustexpansion in credit demand which firmedup since July 2004. Third, the surge inbanks’ non-food credit operations wasaccommodated by a reduction in theGovernment’s borrowing programme.Fourth, movements in inflation driven byinternational commodity prices engagedpolicy attention as an overriding priority.In order to rein in inf lat ion, f iscalmeasures were initiated to contain thepass-through of the increases ininternational oil and non-oil commoditypr ices to domestic inf lat ion, inconjunction with monetary policy actionsto modulate monetary and liquiditycondit ions and prudent supplymanagement. These calibrated policyresponses were able to return inflationfrom a spike in end-August 2004 to 5.1

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per cent by the year end, consistent withthe projection made in the May 2004Annual Policy Statement.

RESERVE MONEY

I.3.2 Reserve money growthdecelerated to 12.1 per cent during 2004-05 from 18.3 per cent during 2003-04.Even as capital flows remained sizeable,base money expansion could becontained due to greater manoeuvrabilityprovided by the operationalisation of theMSS. The slower growth of reservemoney in 2004-05 also reflected the baseeffect of the excess reserves built up onMarch 31, 2004 partly counterbalancedby the 50 basis points increase in thecash reserve ratio (CRR) in two stagesduring September-October 2004, whichimpounded around Rs.9,000 crore in thefirst round. In addition, the remunerationon the banks’ eligible CRR balances waslowered from the Bank Rate (6.0 percent) to 3.5 per cent.

I.3.3 Foreign currency assets(adjusted for revaluation) of the ReserveBank increased by Rs.1,15,044 crore in2004-05 on top of an accretion ofRs.1,41,428 crore in 2003-04, albeit withhigher intra-year variability in 2004-05. Asa result, the ratio of net foreign exchangeassets (NFEA) to currency as well as toreserve money increased further duringthe year.

I.3.4 Consequent upon theoperationalisation of the MSS in April2004, the Reserve Bank’s net credit tothe Government declined by Rs.62,882crore during 2004-05 on top of a declineof Rs.75,772 crore in the previous year.This decline also reflected theimprovement in the fiscal position of theGovernment. The Centre, which hadresorted to ways and means advances

(WMA) on several occasions till earlySeptember 2004, did not avail of WMAin the subsequent per iod. States’recourse to WMA/overdrafts was alsolower in 2004-05 than in the previousyear. The Reserve Bank’s support to theGovernment in the pr imary marketthrough private placement/devolvementwas markedly lower.

MONETARY SURVEY

I.3.5 Broad money (M3) growth at 12.2

per cent during 2004-05 was lower thanthat of 16.7 per cent in the previous yearand well within the projected trajectoryof 14.0 per cent. The deceleration in M

3

reflected, in part, the base effect of higherdeposit mobilisation by commercialbanks during the last quar ter of theprevious year.

I.3.6 Net bank credit to theGovernment increased by only 0.4 percent during 2004-05 mainly due to alower than budgeted borrowingprogramme of the Centre. The sustaineddecline in the Reserve Bank’s net creditto the Government pushed the share ofthe banks in net bank credit to theGovernment to 102.4 per cent at end-March 2005 from 94.0 per cent at end-March 2004 and 37.1 per cent at end-March 1990. Commercial banks’ appetitefor Government paper was moderated bythe upturn in the interest rate cycle.Growth in investments of scheduledcommercial banks in Government paper,at 7.9 per cent during 2004-05, was thelowest since 1985-86. Notwithstandingthis deceleration, commercial banks’holdings of Government securities, at38.5 per cent of their net demand andtime liabilities (NDTL) at end-March2005, remained far in excess of theprescribed statutory minimum ratio of 25per cent.

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I.3.7 A noteworthy feature of monetarydevelopments during the year was theacceleration in bank credit to thecommercial sector. The pick-up incommercial banks’ non-food credit, whichtook root in July 2004, was sustained bythe continued buoyancy in the industrialsector. Credit off-take from commercialbanks, in fact, outpaced growth indeposits with the incremental credit-deposit ratio jumping up to 118.1 per centduring 2004-05 from 49.9 per cent during2003-04. Commercial banks’ non-SLRinvestments also recorded an increase.Reflecting the improvement in equityprices, there were switches in the banks’non-SLR portfolio in favour of equitiesfrom PSU bonds.

I.3.8 Sectoral deployment of bankcredit indicates that the priority sectorcontinued to be the largest recipient ofgross bank credit. This was essentiallyon account of a substantially higherofftake by the ‘other priority’ segment,representing primarily small housingloans (loans up to Rs.15 lakh; Rs.10 lakhprior to September 2004). Large housingloans (above Rs.15 lakh) also maintainedstrong growth. Low interest rates andfiscal incentives have boosted thedemand for housing loans. Credit tomedium and large industries registereda sharp expansion, led by an increase incredit to power, telecommunications,roads and ports, petroleum, gems andjewellery, drugs and pharmaceuticals,textiles, iron and steel and other metaland metal products.

PRICE SITUATION

I.3.9 Inflation firmed up worldwideduring 2004 as higher input demandemanating from global growth and thesustained expansion of the Chineseeconomy pushed up oil and non-oil

commodity pr ices. Hardeninginternational commodity prices as well asdomestic food prices responding to adeficient monsoon fuelled a spurt ininflation in India during the secondquarter of 2004-05. Inflation began toease from September 2004 under theimpact of a mix of fiscal measures tomoderate the pass-through of importedinflation, monetary policy measures tostabil ise inflation expectations, thewaning of the impact of the South-Westmonsoon on agricultural commodityprices and the base effect of the sharpincrease in prices in the last quarter ofthe preceding year.

I.3.10 The international inf lat ionscenario in 2004-05 was essentiallydominated by the developments in thecommodity markets, especially metalsand crude oil. Although the upsurge inthe last quarter of 2003 continued up tothe first half of 2004, non-oil commodityprices stabilised over the rest of 2004 atelevated levels. Due to the depreciationof the US dollar against major currencies,the increase in commodity prices in theinternational markets in US dollar termswas higher than in terms of the Euro orthe Japanese Yen.

INFLATION CONDITIONS IN INDIA

I.3.11 Headline inflation, measured byyear-on-year (y-o-y) changes in thewholesale price index (WPI), moved intwo distinct phases during 2004-05. Thefirst phase covering April-August, 2004witnessed a hardening of domestic pricesof coal, petroleum products, iron ore andmetals, reflecting essentially laggedadjustments to international prices.Petroleum product prices were revisedupward twice in the first phase, effectiveJune 16 and August 1, 2004. Besides,coal prices were also raised by 16.3 per

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cent in June 2004. The situation wasexacerbated by the inadequate anduneven South-West monsoon whichbegan to push up prices of food and non-food agricultural commodities by July2004. Although rice prices hardenedmarginally, jowar price rise acceleratedto double digits by August onexpectations of a sharp decline in outputof coarse cereals. Potato prices also rosesharply in the first half of the year as theunseasonal rainfall affected the crop ontop of a lean season in 2003-04. As aresult, headline inflation climbed to apeak of 8.7 per cent by end-August 2004,more than half of which was due to ironore, metals, mineral oil and coal. It isagainst this backdrop that the Mid-termReview of the Annual Policy Statementplaced the inflation rate for 2004-05, ona point-to-point basis, at around 6.5 percent as against 5.0 per cent projected atthe beginning of the year.

I.3.12 Inflation receded in the secondphase beginning September 2004 as theadverse impact of the South-Westmonsoon turned out to be far morelimited than perceived initially. This wasled by a sharp decline in the prices ofvegetables following the revival of themonsoon in August 2004. With thereceding of drought fears, prices ofoilseeds, edible oils, raw cotton andcotton textiles began declining in line withinternational trends. Petrol prices, raisedearlier on November 5, 2004, weremoderated somewhat effectiveNovember 15, 2004. Sugar pr iceshardened during the year, reflectingreduced domestic supply which alsoaffected international prices.

I.3.13 The impact of fiscal measures inthe form of cuts in excise and customsduties in June and August 2004cushioned the pass-through of the

increase in international commoditypr ices to domestic inf lat ion. Theappreciation of the rupee against the USdollar during August-December 2004 (6.6per cent) also offset some of thepressures of high internationalcommodity prices on domestic inflation.Moreover, the administered nature ofdomestic urea prices limited the pass-through from high international prices.Administered prices of urea in India werenot changed at all dur ing 2004-05,despite an increase of 35 per cent inworld urea prices. Finally, monetarypolicy measures by the Reserve Bankincluding an increase of 50 basis pointsin the CRR in September-October 2004,a 25 basis point increase in the reverserepo rate in October 2004 and re-introduction of overnight reverse repo inNovember 2004, along with the raisingof ceiling of the MSS by Rs.20,000 croresignalled the resolve of the monetaryauthor ity to rein in inf lat ionaryexpectations.

I.3.14 Headline inflation, year-on-year,eased to 5.1 per cent by the end of 2004-05 remaining close to the projection inthe Annual Policy Statement for 2004-05.Annual average inflation, measured byannual changes in the average WPI,accelerated to 6.4 per cent in 2004-05from 5.4 per cent a year ago. Reflectingthe supply side nature of inflation, year-on-year WPI inflation, excluding the fuelgroup worked out to 3.7 per cent in 2004-05 (5.2 per cent last year), well below theheadline rate of 5.1 per cent.

I.3.15 Consumer pr ice inflation, asmeasured by variation in the consumerprice index for industrial workers (CPI-IW), increased from 3.5 per cent in March2004 to 4.2 per cent in March 2005. Theinflation rate had, however, acceleratedto 4.8 per cent in September 2004

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reflecting the increase in food prices(which have a weight of 57 per cent)emanating from the deficient and unevenprogress of the South-West monsoonduring July-August 2004. Food pricescontributed as much as 45 per cent ofthe overall inflation (y-o-y) in September2004. After easing somewhat, CPI-IWinflation firmed up again to 4.4 per centin January 2005 mainly due to anincrease in the prices of housing. Foodprice inflation moderated to 1.6 per centin March 2005 from 4.2 per cent a yearago. While domestic housing prices in theCPI-IW increased sharply by 20.4 percent in 2004-05 as compared with 3.9 percent a year ago, services prices (proxiedby the broad miscellaneous group)increased moderately by 4.1 per cent (3.2per cent in the previous year). On anaverage basis, CPI inflation at 3.8 percent in 2004-05 was marginally lowerthan that of 3.9 per cent a year ago.

Developments during 2005-06

I.3.16 Year-on-year WPI inflationaccelerated to 6.0 per cent by April 23,2005 due to hardening of prices of fruitsand vegetables under seasonal pressuresand some upward adjustment in the pricesof aviation turbine fuel, naphtha, furnaceoil and iron and steel. In view of thepersistently rising international crude oilprices, domestic prices of petrol and dieselwere increased by about 7-8 per cent onJune 20, 2005 after a gap of almost sevenmonths. Electricity prices were also raisedby 5.1 per cent in early June 2005. Despitethese increases, inflation eased to 3.4 percent by August 6, 2005 reflecting the baseeffect of higher prices last year andmonetary policy measures. Consumerprice inflation (Industrial Workers) alsoeased from 4.2 per cent in March 2005 to3.3 per cent by June 2005.

IV. GOVERNMENT FINANCES

I.4.1 Key fiscal indicators for 2004-05show consolidation and improvement inboth Central and State Governmentfinances. The notification of the FiscalResponsibility and Budget Management(FRBM) Act, 2003 set the stage for a front-loaded fiscal correction path for theCentral Government in 2004-05. However,the unanticipated fiscal stressencountered during the course of the yearon account of post-budget dutyconcessions under taken to easeemerging inflationary pressures,increased fertiliser subsidy and the delayin the passage of the Finance Act resultedin slippages from the budgetaryprojections (in respect of both revenueand fiscal deficits in terms of revisedestimates but only revenue deficit in termsof provisional accounts). However, theFRBM targets for fiscal and revenuedeficits were achieved. State financesindicated some improvement in therevenue deficit mainly on account ofincrease in States’ own tax collections andhigher grants from the Centre. With capitalexpenditure overshooting the budgetedlevel, there was a slippage in the fiscaldeficit vis-à-vis the budget estimates.

I.4.2 An overview of the combinedfinances of the Centre and StateGovernments for 2004-05 reveals aconsiderable improvement in the revenuedeficit over the preceding year mainly onaccount of improved tax and non-taxcollections and a decline in interestpayments as a proportion to GDP.

CENTRAL GOVERNMENTFINANCES - 2004-05

I.4.3 The Central Governmentfinances in 2004-05 were guided by theFRBM Act, 2003 and FRBM Rules, 2004.

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The FRBM Rules, inter alia, stipulateminimum annual reductions of 0.5percentage points in the revenue deficit(RD) to GDP ratio and of 0.3 percentagepoints in the gross fiscal deficit (GFD) toGDP ratio. The revised estimates for2004-05 indicate that the FRBM targetswere achieved. The Union Budget for2004-05 had, however, aimed atachieving larger reductions in the GFDand RD than the FRBM thresholds. Thebudget projections could not be met dueto the post-budget duty concessions andincrease in fertiliser subsidy to containinflationary pressures. The time taken forthe passage of the Finance Act alsoimplied that several tax measuresproposed in the Budget could becomeeffective only towards the latter part ofthe year.

I.4.4 Provisional accounts of theCentral Government for 2004-05, whichhave become available subsequently,show that all the key deficit indicatorswere placed lower than the revisedestimates, reflecting higher non-taxrevenues and lower capital expenditure,especially during the last quarter of theyear. In particular, the gross fiscal deficitand the primary deficit were lower by 0.4percentage points of GDP each onaccount of a sharp cut back in capitaloutlays. The fiscal outcome in 2004-05,thus, showed a marked improvementover the performance in 2003-04.Notably, the revenue deficit in 2004-05declined by one percentage point of GDPover 2003-04, achieving twice theminimum annual reduction stipulatedunder the FRBM Act/Rules.

STATE GOVERNMENTFINANCES - 2004-05

I.4.5 Some moderation in f iscalimbalances of State Governments has

been visible in recent years after a periodof deterioration since the early 1990s.There has been a growing urgencysurrounding fiscal consolidation in theStates with the speeding up of variousfiscal and institutional reforms. Therevised estimates for 2004-05 showedslippages in the gross fiscal deficit (GFD)and the primary deficit of States fromtheir budgeted levels. Notably, however,the revenue deficit recorded a declinefrom the budget estimates with its ratioto GDP declining to 1.4 per cent from 1.5per cent. The reduction in the revenuedeficit was brought about mainly by anincrease in States’ own tax collectionsand higher grants from the Centre.Enhanced provisions for capital outlay,mainly in respect of the irrigation sector,resulted in a higher GFD than budgeted.Both the revenue deficit and the primarydeficit turned out to be lower than theiraverage levels during the triennium 2000-03 as well as the second half of the1990s.

I.4.6 The financing pattern of GFDshows that small savings continued toremain the predominant source,accounting for more than two-third of theGFD in 2004-05. Net loans from theCentre remained negative for the thirdyear in succession on account of largerepayments by the States under the DSS.On the other hand, the share of marketborrowings has been increasing over therecent years, reflecting addit ionalallocations under the DSS.

COMBINED BUDGETARY POSITIONOF THE CENTRE AND STATES

I.4.7 An analysis of the combinedfiscal position of the Centre and Statesreveals slippages in the key deficitindicators in the revised estimates for2004-05 from their budget estimates,

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primarily reflecting higher expenditures.Tax collections, both direct and indirect,also turned out to be lower than thebudget estimates during 2004-05. Non-tax revenues, however, exceeded thebudgeted level signif icantly. Theaggregate disbursements were higherthan the budgeted level, mainly onaccount of higher developmentalexpenditure.

FISCAL OUTLOOK FOR 2005-06

Central Government

I.4.8 The Union Budget, 2005-06 waspresented against the backdrop ofsustained growth momentum withintermittent inf lat ionary pressures,upbeat business confidence and strongindustrial recovery supported by a pick-up in non-food bank credit off-take during2004-05. Operationalising therecommendations of the Twelfth FinanceCommission (TFC) and implementationof the State-level Value Added Tax (VAT)necessitated a ‘pause’ in the path set outunder the FRBM Rules, 2004. Againstthis backdrop, the revenue deficit to GDPis pegged at 2.7 per cent in 2005-06. Thefiscal deficit to GDP ratio is budgeted tobe lower by 0.2 percentage point in 2005-06 than in 2004-05 RE (FRBM stipulatesannual reduction of 0.3 percentagepoint). Disinvestment proceeds would nolonger finance budgetary expenditureand would be credited to an ‘InvestmentFund’ to finance social infrastructureexpenditure and to provide capital toviable public sector undertakings.

I.4.9 A decomposition of the gross fiscaldeficit budgeted for 2005-06 brings to thefore the following special features: First, theproportion of revenue deficit to GFD during2005-06 vis-à-vis 2004-05 is budgeted toincrease reflecting the increase in grants

to the States. Second, the share of netlending of the Central Government in GFDis budgeted to turn negative in 2005-06 onaccount of elimination of Plan loans toStates as recommended by the TFC. Third,the proportion of capital outlay to GFD,which rose sharply in 2004-05 due todefence outlays, is budgeted to increasefurther in 2005-06 due to higher capitaloutlays on ‘special area programmes’,‘science’, ‘technology and environment’,‘communications’ and ‘general economicservices’.

State Budgets - 2005-06

I.4.10 The State budgets for 2005-06envisage a sharp correction of fiscalimbalances. All the major deficitindicators are budgeted much lower thantheir levels in the previous year.

I.4.11 The improvement in the revenueaccount during 2005-06 is proposed tobe brought about mainly by thecontainment of growth in non-interestrevenue expenditure. The growth rate ofalmost all major developmental headsunder revenue expenditure is budgetedto decelerate. Within non-developmentalrevenue expenditure, the growth rate ofinterest payments would decelerate,while that of administrative services isexpected to increase sharply. Capitaloutlay is proposed to be enhanced during2005-06, though as a ratio to GDP, itwould remain at the previous year’s level.In the aggregate, the ratio ofdevelopmental expenditure to GDP wouldrecord a larger decline than that of non-developmental expenditure to GDPduring 2005-06.

Combined Budgets - 2005-06

I.4.12 The renewed thrust on fiscalconsolidation at the Centre as well as

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at the State level is manifested in thebudgeted reductions in all the key deficitindicators in terms of GDP; the revenuedeficit and primary deficit are budgetedto decline even in absolute terms. Thereduction in deficits is sought throughbuoyancy in tax collections coupled withdeceleration in expenditure.

I.4.13 Revenue receipts are budgetedto increase solely on account of improvedtax collections. The combined tax-GDPratio is, therefore, budgeted to improveto 16.5 per cent of GDP in 2005-06 from15.8 per cent in 2004-05.

V. FINANCIAL MARKETS

I.5.1 Financial markets operated in anenvironment of uncertainty worldwide.The upturn in the interest rate cycle,threat of sharp currency movementsemanating from large and growing globalmacroeconomic imbalances and highand volatile international crude oil priceswere major sources of r isk. Investorappetite for both mature and emergingmarkets, nevertheless, remained strongbut for a brief lull in the second quarterof 2004-05.

I.5.2 Domestic f inancial marketsremained broadly stable during 2004-05facilitated by the Reserve Bank’s liquiditymanagement. Money markets continuedto be guided by the policy reverse reporate, barring occasional spells of tightliquidity. The foreign exchange marketremained orderly despite the ebbing ofcapital flows during May-October 2004and the r ise in demand for foreignexchange due to higher oil prices. Yieldsin the Government securities markethardened in consonance with highercredit off-take, a resurgence ofinflationary pressures in the first twoquarters of the year and the hardening

of international interest rates. After asetback in May 2004, the equity marketsstaged a strong rally in the second halfof 2004-05.

Money Market

I.5.3 Liquidity in the call/notice moneymarkets remained adequate in 2004-05.Reflecting easy liquidity conditions,average daily call money borrowing ratesgenerally ruled below reverse repo ratelevels, but were anchored to the policyrate.

I.5.4 The gradual phasing out of non-bank participants from the call market,tightening of prudential norms relatingto the cal l exposure of banks andavailabil ity of cheaper funds led toincreased activity in the repo market(outside the LAF). The monthly averageturnover increased by 64.2 per cent toRs.17,135 crore during 2004-05 andfurther to Rs.18,103 crore in July 2005.Apart from banks, mutual funds andfinancial institutions were the mainparticipants in the repo market. The reporates ranged between 3.70 per cent and5.58 per cent during the year, barringoccasional spikes in November andDecember 2004.

I.5.5 The collateralised borrowing andlending obligations (CBLO) marketcontinued to expand during 2004-05. ByJuly 2005, 121 members had beenadmitted in the CCIL’s CBLO segmentout of which 56 were active members.The daily average turnover increasedfrom Rs.2,496 crore in April 2004 toRs.9,625 crore by March 2005 andfurther to Rs.15,291 crore by July 2005.Initially, only one insurance companyand few co-operative banks suppliedfunds in this market. Currently, mutualfunds have emerged as the largestsuppliers of funds. On the demand side,

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apart from banks, PDs have also beenparticipating regularly on account oflower borrowing costs in CBLO vis-à-viscall market.

Certificates of Deposit

I.5.6 The outstanding amount ofcertificates of deposit (CDs) issued byscheduled commercial banks increasedmarkedly during 2004-05, reflecting thebanks’ requirement of funds in view ofsustained increase in credit demand. Thetypical discount rate (for 3-monthmaturity) on CDs also increased by about94 basis points over the year. Issuancesof CDs depend not only on overallliquidity conditions but also on bank-specific factors. In this context, selectforeign and private sector banks havebeen raising resources through theissuance of CDs on account of a smallerretail network and cost effectiveness. Thesteady expansion in issuance of CDsduring 2004-05 was encouraged byfactors such as reduction in stamp dutyon CDs effective March 1, 2004, no taxdeduction at source, no prematureclosure of deposits under CDs vis-à-visalternative competing instruments suchas fixed deposits and greater opportunityfor secondary market trading.Furthermore, mutual funds (MFs) havealso turned to CDs after the Securitiesand Exchange Board of India (SEBI)placed a bar on parking their funds inbank deposits. An encouragingdevelopment was that some of the topissuing banks got their CDs rated forbetter access to the market even whensuch rating was not mandatory under theextant guidelines.

Commercial Paper

I.5.7 The market for commercial paper(CP) continued to remain buoyant during

2004-05. In tandem, the discount ratefirmed up from a range of 4.70-6.50 percent during 2003-04 to 5.20-7.25 per centduring 2004-05, with the weightedaverage discount rate (WADR) moving upfrom 5.11 per cent to 5.84 per cent. Thespread of the WADR between the prime-rated and medium-rated companiesdeclined to 3 basis points during thefortnight ended March 31, 2005 from 73basis points during the fortnight endedMarch 31, 2004. The preferred maturityof CP was for periods ranging from ‘61to 90 days’ and ‘180 days and above’.

FOREIGN EXCHANGE MARKET

I.5.8 The foreign exchange marketremained generally stable during 2004-05. In response to the switches in capitalflows during the year, the rupee movedin a relatively wide range of Rs.43.36-Rs.46.46 per US dollar during the year.The rupee appreciated by 2.2 per centagainst the US dollar on an annualaverage basis while it weakened againstthe euro, the pound sterling and theJapanese yen by 4.5 per cent, 6.3 percent and 2.6 per cent, respectively, during2004-05. Reflecting these cross-currencymovements, the nominal effectiveexchange rate (NEER) depreciated by1.9 per cent during 2004-05.

I.5.9 During April-May 2005, despiteoutf lows by FIIs and a highermerchandise trade deficit, the rupeefirmed up against the US dollar fromRs.43.76 at end-March 2005 to Rs.43.30per US dollar on May 12, 2005. Insubsequent weeks, the Indian rupeedepreciated, reaching Rs.43.76 on June2, 2005 due to strengthening of the USdollar in the international markets. Withthe revaluation of the Chinese yuan onJuly 21, 2005, there were appreciationpressures and the rupee stood at

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Rs.43.58 per US dollar on August 19,2005. On the whole, the Indian rupeeappreciated by 0.4 per cent over its levelon March 31, 2005.

GOVERNMENT SECURITIESMARKET

I.5.10 Yields hardened in theGovernment securities market reflectingthe upturn in the international interestrate cycle, rise in international crude oilpr ices, domestic monetary policytightening and edging up of inflation inthe first half of 2004-05.

I.5.11 During 2004-05, the yield curveunderwent an upward shift. Thesecondary market yields on the 10-yearGovernment securities moved up by 150bps between end-March 2004 and end-March 2005.

I.5.12 During 2005-06, yields started toharden from the second week of April2005, ref lect ing a fur ther r ise ininternational crude oil prices, higherthan expected inflation and a hike in thereverse repo rate. The 10-yearbenchmark yield firmed up to 7.31 percent on April 30, 2005 from 6.65 per centon March 31, 2005. Yields softenedduring the first three weeks of May 2005with the decline in international crudeoil prices and easing of inflation. Ascrude oil prices renewed their upwardclimb, the 10-year yield hardened to 7.23per cent as on July 11, 2005. With thereverse repo rate being left unchangedon July 26, 2005 in the First QuarterReview of the Annual Statement onMonetary Policy, yields softened undercomfor table liquidity conditions andstood at 7.08 per cent on August 19,2005. Thus, yields hardened by 43 basispoints between end-March and August19, 2005.

CREDIT MARKET

I.5.13 Despite a strong pick-up in creditdemand, deposit and lending rates ofbanks remained broadly stable, reflectingappropr iate l iquidity in the system.Deposit rates, in fact, eased till December2004 before edging up in March 2005.Public sector banks (PSBs) realignedtheir deposit rates in the tenor of one yearand above to 5.25-6.50 per cent by June2005 from a range of 4.75-7.00 per centin March 2005.

EQUITY AND DEBT MARKETS

I.5.14 Strong macroeconomicfundamentals kept the capital marketbuoyant during 2004-05. The primarysegment benefited from the positivesentiment in the secondary market andan upbeat investment climate. Equityissues by corporates through initialpublic offerings recorded a substantialincrease. Pr ivately placed debtissuances by public sector companiesdominated the primary market segment.Issuances in international markets byIndian corporates also increased duringthe year. Stock markets recovered fromthe setback of May 2004 to touch all-time high levels towards the close of theyear. During the most part of the periodNovember 2004-March 2005, the BSESensex remained above the 6000-mark.The BSE Sensex reached new highsduring July-August 2005, closing at7,860 on August 17, 2005. The rise inindices was accompanied with a sharpincrease in turnover in a market flushwith liquidity. The rally in the stockmarkets was broad-based and spreadwidely across smal l and mid-capcompanies from various sectors. FIIsevinced keen interest in the Indiancapital market.

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I.5.15 Resource mobilisation from theprimary market through public issues(excluding offers for sale) almost trebledduring 2004-05. The average size of apublic issue was substantially higher atRs.371 crore in 2004-05 than Rs.168crore in 2003-04 and Rs.106 crore duringthe five-year period 1999-2004. Theamounts raised through public issuesmore than doubled to 0.7 per cent of GDPin 2004-05 from 0.3 per cent in theprevious year.

I.5.16 The share of the initial publicofferings (IPOs) by unlisted companiesincreased substantially during 2004-05,both in terms of number of issues andamounts raised. Out of 59 public issues,23 issues were IPOs, constituting 24.4per cent of the total resourcemobilisation. All the IPOs generatedenthusiastic investor response. Equityissues constituted 82.3 per cent of thetotal resource mobilisation through publicissues during 2004-05 as compared with43.7 per cent during the previous year.Out of the 59 public issues during 2004-05, only five were debt issues. The Indiancorporate sector has been relying on theprivate placement route for raising debtalongside tapping the internationalmarkets.

I.5.17 The stock market exhibitedsustained buoyancy in the latter half of2004-05 after a volatile period duringApr il-June 2004. Gaining a speedyrecovery from the decline on May 17,2004, the BSE Sensex gatheredmomentum to close at its intra-year peakof 6915 on March 8, 2005. The dramaticdrop in the Indian stock markets on May17, 2004 reflected domestic politicaluncertainties as well as adverse investorsentiment in many other emerging marketeconomies. Stock markets in SouthKorea (-5.1 per cent), Taiwan (-5.1 per

cent) and Thailand (-4.6 per cent) alsodeclined on the same day. The concernsarising out of the imposition of thesecurities transaction tax had a short-lived impact on the markets.

I.5.18 Buoyant conditions resumed inthe market during the second half ofAugust 2004 in l ine with posit ivesentiments in world equity markets. Therobust macroeconomic outlook,encouraging investment climate, stronginvestments by FIIs, policy initiativesrelating to foreign direct investment intelecom and construction sectors andimpressive financial performance ofIndian companies were the main factorsthat boosted the market sentiment in thesecond half of the f inancial year.Consistent growth in corporate profitswas a key factor dr iving markets.Moderation in domestic inflation andeasing of international crude oil pricesalso contributed to the upsurge.

VI. EXTERNAL SECTOR

I.6.1 Several significant developmentsunderscored the strength and vibrancyin India’s external sector in 2004-05. First,merchandise export growth exceeded 24per cent in US dollar terms, extending aphase of high growth that began in 2002-03. Second, there was a massiveincrease in merchandise imports, drivenup by the upsurge in international crudeoil prices and a strong resumption ofdomestic investment demand. As aconsequence, the trade deficit increasedsubstantially dur ing 2004-05. Third,notwithstanding strong growth in netinvisible receipts – mainly backed byservices exports and remittances fromIndians employed abroad – the currentaccount slipped into a modest deficit aftera continuous span of three years ofsurpluses. Fourth, private capital, led by

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por tfolio f lows in stock exchanges,endorsed the attractiveness of the Indianeconomy relative to other emergingmarket economies (EMEs) as aninvestment destination on account of itsstrong macroeconomic performance.Fifth, the intermittent surges in portfolioflows were accompanied by sizeableexpansion in recourse to debt flows in theform of trade credit – both short and long-term. The favourable sentiment for Indiain international financial markets wasbuoyed up by upgrades of the sovereignrating in 2004-05 by Standard & Poor’sRating Services. Sixth, by March 2005,India had accumulated the fifth largeststock of international reserves in theworld, sufficient to finance about 14months of imports. As a result, India’sinternational investment position showeda marked improvement. The robustexternal sector performance facilitatedfurther liberalisation of the exchange andpayments system.

INTERNATIONAL DEVELOPMENTS

I.6.2 Global GDP expanded by 5.1 percent during 2004 - the highest rate ofgrowth since 1976. In advancedeconomies, growth accelerated to 3.4 percent in 2004 from 2.0 per cent in 2003, ledby the US; in emerging market anddeveloping economies, it accelerated to 7.2per cent from 6.4 per cent. With GDPgrowing by 9.5 per cent, driven by strongfixed investment demand and exports,China emerged as the world’s fastestgrowing economy, underpinning thestrength of global growth. The accelerationin global economic activity wasaccompanied by a doubling of the growthof world trade volumes from 4.9 per centin 2003 to 9.9 per cent in 2004.

I.6.3 Private capital flows to emergingmarket and developing countr ies

increased to near 1997 (pre-Asian crisis)levels during 2004, mainly in the form offoreign direct investment (FDI) flows. Asiacontinued to be a major recipient, led byChina. The western Hemisphere alsoreceived a signif icant increase,particularly, Mexico and Brazil, boostedby increased cross-border merger andacquisition activity in the banking andmanufacturing sectors.

BALANCE OF PAYMENTS

I.6.4 After three years beginning in2001-02, India’s balance of paymentsrecorded the return of a current accountdeficit in 2004-05. The turnaround wasdriven by the merchandise trade deficitreaching 5.5 per cent of GDP, butunderpinned by an intrinsic link betweenimport intensity and export performance.In the capital account, the surge in importswas manifested in a large recourse tooverseas borrowings by Indian banks,trade credits and external commercialborrowings. According to the WorldEconomic Outlook (April 2005), portfolioflows to India accounted for 30.6 per centof global flows to EMEs and developingcountries in 2004. Inflows of FDI alsopicked up strongly during the year. Theaccretion to reserves, excluding valuationeffects, was of the order of US $ 26.2billion, somewhat lower than in 2003-04.

Merchandise Trade

I.6.5 Both expor ts and impor tsrecorded sharp growth during 2004-05,reflecting the onset of internationalcompetitiveness of the manufacturingsector in an environment of expandingtrade integration, a supportive domesticpolicy framework, sustained recovery inglobal demand and an increase ininternational commodity prices. Exportsat US $ 79.3 billion during 2004-05

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registered a growth of 24.1 per cent, thehighest recorded in the last threedecades and substantially higher than theannual target of 16 per cent set by theMinistry of Commerce and Industry.Export growth was broad-based acrossmajor product groups.

I.6.6 Expor ts of manufacturedproducts maintained growth momentum(20.0 per cent in 2004-05 as comparedwith 20.5 per cent recorded in 2003-04).Among the key dr ivers, expor ts ofengineering goods were buoyed up bytechnology-intensive items like metal,machinery and instruments, transportequipment, electronic goods and iron andsteel due to demand picking up in EastAsia, China and non-traditional marketslike Latin America and Africa. Exports ofgems and jewellery continued to recorda sharp increase, reflecting the benefitsof various promotional measures as wellas recovery in major markets like the US.Exports of petroleum products surged by90.3 per cent, reflecting the expansionin domestic refining capacity and higherinternational prices of refined products.India emerged among the top f ivepetroleum refining countries in the world.In the texti le segment, expor ts ofdomestic raw materials (cotton yarn,fabr ics, made-ups) and readymadegarments declined while those usingsynthetic/ impor ted raw mater ials(manmade yarn, fabrics, made-ups, etc.)recorded a significant increase. Worldtrade in textiles and clothing is gearedfor a more competitive environment dueto the elimination of quota restrictionsunder the Multi-Fibre Arrangement witheffect from January 2005.

I.6.7 Imports at US $ 107.1 billiongrew by 37.0 per cent in 2004-05 - thehighest since 1980-81 - on top of 27.3per cent in 2003-04. Oil imports at US $

29.8 billion shot up by 45.1 per cent in2004-05, mainly on account of the surgein international crude oil prices as involume terms, the growth rate of oilimports slowed to 5.5 per cent in 2004-05 from 10.6 per cent in 2003-04.

I.6.8 Non-oil imports maintained themomentum of growth recorded in theprevious year, in tandem with the pick-up in domestic manufacturing activity.Non-oil imports, excluding gold andsilver, increased by 30.9 per cent during2004-05. Imports of mainly industrialinputs (non-oil imports net of gold andsilver, bulk consumption, manufacturedfertilisers and professional instruments)grew by 32.8 per cent during 2004-05 ascompared with 29.1 per cent during2003-04. Imports of capital goods (mainlycompr ising metals, machine tools,machinery and electronic goods), inparticular, posted a significant growth of23.5 per cent during 2004-05 on the topof 35.4 per cent growth during 2003-04.During 2004-05, imports of gold andsilver at US $ 10.8 billion posted a highgrowth of 57.9 per cent, similar to theincrease during 2003-04.

I.6.9 The merchandise trade deficit atUS $ 27.8 billion during 2004-05 toucheda historic peak with the increase in non-oil imports (US $ 29.8 billion) being themajor contributing factor. The non-oilt rade balance, which remained insurplus during 2000-01 to 2003-04,turned into a deficit of US $ 4.8 billionduring 2004-05.

Invisibles

I.6.10 During 2004-05, the net invisiblesurplus at 4.6 per cent of GDP was able tofinance 83.1 per cent of the trade deficit.Service exports and remittances fromIndians working abroad were the keydrivers. Gross earnings from invisibles

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constituted 49.1 per cent of externalcurrent receipts in 2004-05, significantlyabove 29.3 per cent in 1990-91.

I.6.11 According to the IMF’s Balanceof Payments Statistics Yearbook 2004,India emerged as the 18th largest serviceexporter in the world in 2003, expandingits market share to 1.3 per cent from 0.6per cent in 1990. Services exports wereled by rapid r ise in business andprofessional services, t ravel andsoftware services. The compositionalshift in favour of software and businessservices became even more pronouncedin 2004-05.

Current Account

I.6.12 Reflecting the sharp rise in themerchandise trade deficit, the currentaccount turned into a deficit from thesecond quarter of 2004-05 onwards andfor the year as a whole, it was 0.9 percent of GDP. In a national accountingperspective, the re-emergence of acurrent account deficit in 2004-05represents a cessation of a brief periodof export of domestic saving and theresumption of the supplemental role offoreign saving in f inancing higherinvestment and growth in the economy.This augurs well for the higher growthtrajectory envisaged for the Indianeconomy over the medium-term. Manyother EMEs such as China, Malaysia, thePhilippines, Thailand, Korea, Indonesia,Argentina and Brazil, however, continuedto record significant current accountsurpluses reflecting the counterpart tothe massive current account deficit ofthe US.

Capital Account

I.6.13 Capital account developmentscontinued to dominate the balance of

payments outcome in 2004-05. In the firsthalf of 2004-05, there was a considerableslowdown in foreign investment inflowswhile NRI deposits recorded outflows.Foreign investment inflows picked upsharply in the second half mainly onaccount of a revival of FII interest inIndian equities. External commercialborrowings and trade credit rose sharplyduring the second half of the year.

EXTERNAL DEBT

I.6.14 India’s external debt stockincreased by US $ 11.6 billion (10.4 percent during 2004-05) to US $ 123.3 billionat end-March 2005. All components ofexternal debt, except bilateral aid andrupee debt, recorded an increase.Commercial borrowings increasedsharply during the year as access of thecorporates to international capitalmarkets improved during the year. Short-term debt, particularly trade credits, alsosurged on account of f inancingrequirements of the higher import growth.The US dollar continues to dominate thecurrency composition of India’s externaldebt stock.

I.6.15 Indicators of external debtsustainabi l i ty fur ther strengthenedduring the year. The ratio of externaldebt to GDP showed a steadyimprovement, dropping to 17.4 per centat end-March 2005 from 30.8 per centat end-March 1995. The foreign currencyassets of the Reserve Bank provided acover of around 110 per cent of totalexternal debt outstanding on March 31,2005. India was the eighth largest debtorcountry in 2003; however, among the top20 debtor countries, India had the lowestdebt-GDP ratio, next only to China. Theratio of the shor t-term debt to totalexternal debt was also among the lowest

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for India and was placed at 6.1 per centat end-March 2005 as against anaverage of 15.7 per cent for thedeveloping countries as a group.

FOREIGN EXCHANGE RESERVES

I.6.16 India’s foreign exchangereserves comprising foreign currencyassets, gold, SDRs and the reserveposition with the IMF increased by asmuch as US $ 28.6 billion during 2004-05 and stood at US $ 141.5 billion as onMarch 31, 2005. India turned a creditorto the IMF under the FinancialTransactions Plan (FTP) in 2003. During2004-05, US $ 93.5 million (SDR 61million) was made available under theFTP to countries like Uruguay, Haiti,Dominican Republic and Sri Lanka.

I.6.17 At end-March 2005, India heldthe fourth largest stock of internationalreserve assets among EMEs. In terms oftrade-related reserve adequacyindicators, India’s foreign exchangereserves at 14.3 months of imports arehigher than other EMEs in Asia. India’sratio of reserves to shor t-term debtcomfor tably satisfies the adequacycriterion vis-à-vis comparator countries.In terms of overall external debt and totalexternal liabilities, India’s reserves are

ECONOMIC REVIEW

broadly adequate. In view of the steadyimprovement in the external sector andgrowth prospects, Standard & Poor’sRating Services raised its long-termforeign currency rating on India by onenotch to ‘BB+’ (still one notch below theinvestment grade) and affirmed its ‘BB+’long-term local currency and short-termratings on February 2, 2005.

INTERNATIONAL INVESTMENTPOSITION

I.6.18 India ’s net in ternat ionalinvestment position, i.e., the stock ofexternal assets net of the stock ofexter nal l iab i l i t ies, improvedsignificantly. Net external l iabil it iesdeclined to US $ 48.6 billion by end-March 2004 from US $ 60.6 billion atend-March 2003. International assetsgrew much faster than internationalliabilities, attributable to the marked risein reserve assets. The ratio of India’sreserve assets to total internationalassets compares favourably with manyEMEs. Ref lect ing these posi t ivedevelopments, the ratio of net foreignliabilities to GDP for India recorded asteady improvement from 21.0 per centat end-March 1997 to 7.7 per cent atend-March 2004.

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II ASSESSMENT AND PROSPECTS

ASSESSMENT OF 2004-05

II.1 Against the backdrop of thegrowth peak in 2003-04, India’smacroeconomic performance in 2004-05was heartening in the face of threats togrowth from an unsatisfactory monsoonand upside risks to stability from high andvolatile international crude oil prices. Theimprovement in rabi production helped inshoring up kharif output losses andimparting resilience to Indian agriculture.A distinct dynamism exhibited by themanufacturing sector underpinned astrong and well-distributed industrialrecovery that contributed to accelerationin overall economic activity, infusingbusiness confidence, expor tcompetit iveness and a pick-up ininvestment intentions. In conjunction withthe sustained buoyancy of the servicessector, these impulses of growthmitigated, to a large extent, the setbackto agriculture. Accordingly, the Indianeconomy remained among the growthdrivers of the global economy, whichexhibited high overall growth despitevar ious uncer tainties and r isks.Coordinated and carefully calibratedmonetary and fiscal policies, deployed toaddress the spike in inflation during May-August, 2004 were successful incontaining inf lat ion to i ts desiredtrajectory in the last quarter of the year.Never theless, pressures frominternational crude prices as well as fromthe burgeoning domestic demand spilledover into the balance of payments,leading to strong import growth and awidening trade deficit signalling, to some

extent, better absorption as well asresil ience in the economy.Understandably, after recordingsurpluses for three years, the currentaccount exhibited a deficit. Net capitalflows were higher than those recordedin the previous year, partly reflectingglobal trends and partly drawn by theunder lying strength of themacroeconomic fundamentals andoutlook, the robust performance of thecorporate sector and the attractivevaluations of Indian financial markets. Atthe end of 2004-05, India’s foreignexchange reserves were the sixth largestin the world, surpassing the level ofIndia’s external debt.

II.2 The manufactur ing sector’supsurge was the highlight of India’smacroeconomic performance during2004-05, consolidating a phase ofindustrial recovery that began in 2002-03. Despite subdued activity ininfrastructure, industr ies such asmachinery and equipment other thantranspor t equipment, chemicals andchemical products, cotton textiles andtexti le products contr ibuted to theresurgence of the manufacturing sector.Capital goods and consumer goodssectors recorded double-digit growth,supported by a broad-based expansionin demand, both domestic and external.The coincident expansion of exports withthe renewed growth of the manufacturingsector is indicative of the acquisition ofthe cutting edge of competitiveness anda greater penetration of overseasmarkets by Indian industry than before.

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Furthermore, the experience of 2004-05also shows that a significant amount ofinnate resilience has been built up,especially in the context of exogenousshocks such as the deficient monsoon,the tsunami and soaring international oilprices.

II.3 The services sector consolidatedand extended gains in activity during2004-05. Within the services sector,trade, hotels, transpor t andcommunication has achieved an averagegrowth of 9.8 per cent during the last fiveyears. The trade and transport sectorsbenefited from factors such as thebuilding of new highways, the cut incustoms duty on the inputs of autocomponents which boosted theproduction of tractors and commercialvehicles, increase in cargo handled atmajor ports and increase in freight andpassenger traffic of railways. Growth ofthe hotel industry was facilitated by arecord increase in tourist inflows into thecountry. Lower tariffs in the cellularsegment due to intense competitionamong the operators and higherpenetration into the rural areasmaintained the growth momentum in thetelecommunication sector. The servicessector continued to benefit from exportsof software services, especially ITES-BPO, reflecting the ability of the Indianfirms to execute larger and more complexprojects as well as high value addedservices. Thus, buoyancy in theinformation technology sector, significantgrowth of the telecommunications andtransport sectors, and strong foreigntourist arrivals contributed to maintainingthe momentum in the services sectorgrowth.

II.4 Despite a sharp rise in oil importson the back of high international crudeoil prices as well as a surge in non-oil

impor ts reflecting growing domesticindustrial demand, India’s balance ofpayments position remained comfortablewith foreign exchange reservesincreasing by US $ 28.6 billion during2004-05. There are significant shiftswithin the balance of payments thatsuggest that the economy may beapproaching a turning point. First, theimport-GDP ratio increased to 17.2 percent in 2004-05, after hovering around13 per cent during the previous five years.Second, expor t growth was robust,increasing by more than 20 per cent perannum for the third consecutive year inUS dollar terms. Third, the merchandisetrade deficit reached 5.5 per cent of GDP.The non-oil trade balance turned intodeficit after a gap of four years. Fourth,overall earnings from net invisibles werebuoyant, benefiting from steady growthin software and business servicesexports as well as remittances fromexpatriate Indians. However, net travelreceipts were negative, because of therapid expansion in outbound tourist fromIndia, despite the jump in tourist arrivals.Fur thermore, there was a sharpexpansion in payments for businessservices in consonance with themodernisation of Indian industry. As inthe past, the investment income accountrecorded net outflows on account ofinterest payments on external debt andprofits and dividend payments.Nonetheless, more than four-fifth of thetrade deficit was financed by the netinvisible surplus. Fifth, there was aturnaround of US $ 17 billion in thecurrent account balance during 2004-05– a modest deficit of 0.9 per cent of GDPin 2004-05 from a surplus of 1.7 per centof GDP in the previous year, 1.2 per centin 2002-03 and 0.7 per cent in 2001-02.Sixth, the sharp increase in merchandiseimpor ts and the expanded external

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financing requirements led to a step-upin recourse to debt flows - trade creditand external commercial borrowings(ECBs) - alongside large investmentflows pulled in by sustained investoroptimism about India. Finally, positiveaspects of these developments and thestrength of the reserves created acongenial environment for expandingIndia’s foreign investment overseasreflecting India’s managerial,technological and entrepreneurialcapabilities.

II.5 Given the growing integration ofthe Indian economy with the rest of theworld, the external sector outcome duringthe year reflected global developments,par t icular ly the movements ininternational oi l pr ices and theuncer tainties surrounding globalmacroeconomic imbalances andcurrency movements. The global oileconomy continued to be characterisedby elevated prices and considerablevolatility, accentuated by speculativeactivities. Progressive withdrawal of theaccommodative stance of monetarypolicy in the US alongside a weakeningof economic activity in the euro area wasyet another source of uncertainty forfinancial markets.

II.6 Public finances exhibited someconsolidation in 2004-05, demonstratinga renewed commitment by theGovernment towards rule-based fiscalpolicy at the Centre and in a number ofStates. Notably, the revenue deficit in theCentre’s provisional accounts for 2004-05 declined by one percentage point ofGDP over 2003-04, achieving twice theminimum stipulated annual reduction setunder the Fiscal Responsibility andBudget Management (FRBM) Act/Rules.The reduction in the gross fiscal deficit,relative to GDP, was also higher than the

FRBM target. Some headway in taxreforms was made by introducing newtaxes, expanding the tax base andsprucing up tax administration whileretaining stabil i ty in the tax rates.Expenditure management was gearedtowards reducing low pr ior ityexpenditures and reor ientingexpenditures towards achieving physicaltargets. Nevertheless, low and shrinkingcapital outlays constraining theexpansion of infrastructure andrealisation of the full potential of theeconomy, emerged as a key concern.Furthermore, the Government’s attemptto moderate the impact of spur tinginternational oil prices by allowing onlytheir partial pass-through to consumershas affected the performance of domesticoil companies.

II.7 A notewor thy aspect ofmacroeconomic management during2004-05 was the success in restraininginflation and inflationary expectations inan environment of severe supply shocksemanating from a sharp r ise ininternational crude oil prices and thesetback to agricultural production causedby a deficient monsoon. Inf lat ion,measured by movements in wholesaleprices, reached its intra-year peak of 8.7per cent by end-August 2004 beforemoderating to 5.1 per cent by end-March2005 in response to calibrated policymeasures. The policy response includedfiscal measures in the form of cuts inexcise and customs duties and monetarymeasures to withdraw excess liquidityfrom the financial markets.

II.8 Whi le persever ing with i tsobjective of provision of liquidity to meetcredit growth and support investmentand export demand in the economy,monetary policy assigned relatively

37

greater weight to pr ice stabil i ty byswitching from ‘a very close watch onthe movements in the price level’ in theAnnual Policy Statement (May 2004) to‘equal emphasis on price stability’ in itsMid-term Review (October 2004). Thiswas supported by a 50 basis pointsincrease in the cash reserve ratio (CRR)in September-October 2004 and a 25basis points hike in the reverse repo ratein October 2004. With a view tomanaging liquidity pressures emanatingfrom large and persistent capital flows,sterilisation operations were undertakenthrough the liquidity adjustment facility(LAF) and open market operations,supported by the Market StabilisationScheme (MSS). These operations weresuccessful in keeping monetaryconditions stable and well within theirindicative trajector ies set out in theAnnual Policy Statement for 2004-05.

II.9 Financial markets in Indiaremained broadly stable during 2004-05,notwithstanding the uncer taintyassociated with the upturn in the globalinterest rate cycle and growing globalmacroeconomic imbalances. Theintroduction of the MSS, effective April2004, provided the Reserve Bank withgreater flexibility to absorb liquidity of arelatively durable nature and to modulatel iquidity condit ions in the f inancialmarkets, consistent with monetary andfinancial stability objectives. Comfortableliquidity kept money market segmentsaligned with the reverse repo rate duringthe greater part of the year. The foreignexchange market remained orderly,despite upward pressures on the rupee.Yields in the Government securitiesmarket hardened, mainly reflectingincrease in the inflation rate due to highercrude oil prices and increase in thereverse repo rate. In the credit market,

commercial credit offtake remainedexceptionally strong and broad-based.The equity market staged unusuallystrong rallies from intra-year lows in May2004.

II.10 The conduct of f inancialregulation and supervision in 2004-05continued to be guided by the objectiveof maintaining confidence in the financialsystem by enhancing its soundness andefficiency. In addition to fine-tuning theprudential guidelines, the Reserve Bankfocused on encouraging marketdiscipl ine and ensur ing goodgovernance with an emphasis on “fit andproper” owners and diversi f iedownership. Steps to implement Basel IInorms were carried forward through theCapital Adequacy Assessment Process.In respect of urban cooperative banks,the policy endeavour during the yearaimed at developing them into a sound,well managed network of f inancialinstitutions providing quality bankingservices to the widest sect ions ofsociety. Final ly, the Reserve Bankstressed f inancial inclusion byemphasising the faci l i tat ion oftransactions by the common person andstrengthening of the credit deliverysystems as a response to the pressingneeds of society and the economy.

II.11 The Reserve Bank continued withits efforts to develop a sound and efficientpayment and settlement system. During2004-05, the thrust of the Reserve Bank’spolicy initiatives was on widening therange of electronic payment products andbuilding a sound institutional frameworkfor regulation and supervision. Theestablishment of the National FinancialSwitch and the stabilisation of the realtime gross settlement (RTGS) systemwere noteworthy developments duringthe year.

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OUTLOOK FOR 2005-06

II.12 Leading indicators and availableinformation for 2005-06 suggest that theIndian economy is poised to build uponthe gains in macroeconomic performancesecured in 2004-05. The revival of theSouth-West monsoon, robuststrengthening of manufacturing activity,high corporate profitability, buoyantequity markets, robust merchandiseexports and imports, sustained demandfor non-food credit and lead indicators ofservices sector activity all point to abrightening of the near term prospectsof the Indian economy.

II.13 According to the IndiaMeteorological Department (IMD), therainfall during the South-West monsoonseason 2005 for the country as a wholeis expected to be 98 per cent of the longperiod average with a model error of +/-4 per cent. The monsoon, which wasdelayed by a week, recorded a deficiencyof as much as 49 per cent till June 22,2005. In the subsequent weeks, however,there was conspicuous improvement inrainfall activity. The cumulative rainfallduring the period June 1 to August 17,2005 was two per cent below normal asagainst seven per cent below normalduring the corresponding period of theprevious year. Of the 36 meteorologicalsub-divisions, cumulative rainfall wasexcess/normal in 29 sub-divisions (28sub-divisions during last year). Althoughthe delayed arrival had an adverse impacton sowing of kharif crops, the sowing hasstar ted picking up. The Ministry ofAgriculture is closely monitoring thesituation and has issued advisoriesrelating to sowing with specif icsuggestions to farmers on the likelyagr icultural operations they mayundertake in the context of expectedweather conditions. However, excess

rainfall in some areas in the countryduring the last week of July 2005 not onlyimpacted the economy of the industrial/commercial capital (Mumbai) but has alsointroduced some uncertainty regardingthe eventual kharif outcome.

II.14 Industrial production gatheredstrength in April-June 2005 with growthaccelerating to double digit. On a year-on-year basis, the growth of themanufacturing sector in June 2005 wasthe highest since June 1996. Theelectricity sector recorded a strong pick-up in May-June 2005 and the cumulativegrowth during April-June 2005 was higherthan a year ago. Amongst otherinfrastructure industries, finished steeland cement recorded a robustturnaround in June 2005 from absolutedeclines a year ago while crude oil andpetroleum refinery products remainedlacklustre. According to the use-basedclassification, the capital goods sectormaintained strong growth, reflectingincrease in both investment and exportdemand. Growth of consumer durablesaccelerated, driven by demand for whitegoods and faci l i tated by ease inavailability of financing. Consumer non-durables also recorded a substantialgrowth, partly reflecting the low base andhigh growth of food products. Basic goodsaccelerated during May-June 2005 andthe cumulative growth during April-Junewas higher than a year ago. Intermediategoods, however, recorded deceleration,mainly due to a decline in the productionof petroleum refinery products.

II.15 Var ious surveys of businessconfidence suggest considerableoptimism about future prospects ofindustry. Corporate profits and newinvestment intentions are also at a recordlevel. The optimistic investment climate,broadly stable bank lending rates,

39

corporate profitability and the buoyancyin the stock markets suggest that theindustrial sector outlook is likely to remainbuoyant in 2005-06.

II.16 Lead indicators of services sectorgrowth such as tourist arrivals, railwaysfreight traffic earnings, cargo handled atmajor ports, cell phone connections, civilaviation and trends in bank deposits/credit indicate that the services sector islikely to maintain its growth momentumduring 2005-06 as well.

II.17 Assuming a normal monsoon,and on the expectations that the industryand the services sectors would maintaintheir current growth momentum whileabsorbing the impact of oil prices, theReserve Bank in i ts Annual PolicyStatement for 2005-06 (April 2005)indicated that real GDP growth for 2005-06 could be placed around 7.0 per centfor the purpose of monetary policyformulation. This was reaffirmed in theFirst Quar ter Review of the AnnualStatement on Monetary Policy (July2005).

II.18 Developments in merchandisetrade during the first four months of 2005-06 show that both exports and importshave posted high growth. Non-oil importgrowth (38.1 per cent) mirrored the step-up in the pace of industrial activity whileoil import growth (32.3 per cent) waslargely the outcome of a continued risein international crude oil prices. Withgrowth in impor ts outpacing expor tgrowth - which was 21.3 per cent in USdollar terms - the merchandise tradedeficit increased by 82 per cent duringApril-July 2005. Capital flows were steadyduring the first quar ter. FDI inflowsincreased substantially while FII inflowsrecorded a sharp pick-up in June-July2005. Data on approvals for the ECBs

indicate continued demand for externalfinance for investments by corporates. Asa result of these developments, theburgeoning trade deficit wasaccommodated by the invisibles surplusand net capital f lows. The foreignexchange reserves increased by US $1.7 billion during 2005-06 (up to August19, 2005).

II.19 The resurgence in serviceexpor ts noticed in 2004-05 may beexpected to continue as expor ts ofbusiness and professional services joinsoftware exports as key foreign exchangeearners. The shift in the strategy of ITES-BPO industry segment of the softwaresector towards higher value activities andareas of competitive strength would yieldr ich dividends if suppor ted bypreparedness to meet data securityrequirements and to fulfil regulatorycompliance requirements in the bankingand financial services sector. Workers’remittances seem to have acquired apermanent character and hence shouldcontinue to be an important source ofinflows with an ongoing transition tohigher skil l categor ies in overseasmarkets. Thus, there are grounds to holdthat the buoyancy in net invisible earningswill be maintained and even built upon,despite rising invisible payments. On theother hand, despite the sustainedstrength of expor t performance, themerchandise trade deficit is expected tobe somewhat higher in 2005-06 than theprevious year mainly on account ofsubstantially higher oil and non-oilimports. For the year as a whole, whileinvisibles surplus may finance a largepart of the enlarged trade deficit, thecurrent account deficit is expected towiden during 2005-06 but to remainwithin acceptable limits that can befinanced by normal capital flows.

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II.20 Continuing and emerging globaluncertainties embedded in the pace ofthe tightening of interest rates in the US,asset price movements and the mannerof unwinding of global macroeconomicimbalances would have a bearing oncapital f lows to emerging marketeconomies (EMEs). However, theunder lying strength of the Indianeconomy and the prudent policyapproach should enable containment ofexcess volatility in capital flows to India.Backed by progressive liberalisation ofthe investment environment, Indiancompanies are also expanding anddiversifying their operations across awider spectrum of countries, leveragingadvantages in terms of diffusion oftechnical innovation and managerialexpertise. The notable optimism in India’sgrowth prospects has increased interestin investment in India.

II.21 Although headline inflation edgedup during April 2005 driven up by pricesof fruits and vegetables and some freely-priced items in the fuel group, it eased inthe subsequent months despite hikes inthe prices of electricity and petrol anddiesel. Annual WPI inflation rate was 3.4per cent as on August 6, 2005, down from5.1 per cent at end-March 2005. Morethan one-half of the annual inflation wason account of the fuel group, even as thepass-through from high internationalcrude oil prices has remained incomplete.Excluding the fuel group, annual inflationwas 1.8 per cent as on August 6, 2005,significantly lower than headline inflation.During 2005-06 so far, oil prices in theinternational markets continue to remainhigh and volatile. The average price for abasket of major international crudevarieties (Brent, WTI and Dubai Fateh)at around US $ 52.2 per barrel duringApril-July 2005 was 13.1 per cent higher

than in January-March 2005 and 44.1 percent over the corresponding period of lastyear. With the latest hike in priceseffective June 20, 2005, the averagedomestic price of petrol and diesel (infour metros) has increased by 6.2 percent over the end-March 2005 level and22.4 per cent over the level a year ago.The pass-through of crude pr icescontinues to remain the most criticalfactor influencing domestic inflation.Annual inf lat ion, as measured byvariations in the consumer price index(CPI) for industrial workers, on a point-to-point basis, was 3.3 per cent in June2005 as compared with 3.0 per cent ayear ago.

II.22 The Reserve Bank sought tomoderate inflationary expectations by ademonstrable commitment to pr icestability through successive increases of25 basis points each in the reverse reporate in October 2004 and April 2005. Onbalance, under lying inf lat ionarypressures appear to have been containedduring 2005-06 so far and the inflationoutcome, under normal circumstances,as noted in the First Quarter Review ofthe Annual Statement on Monetary Policy(July 2005), is expected to be consistentwith the Annual Policy Statement’sprojection for annual point-to-pointinflation for 2005-06 in the range of 5.0-5.5 per cent.

II.23 The performance of CentralGovernment finances during 2005-06has so far been in line with the budgetestimates. The Central Government’sfinances during April-June 2005 werecharacterised by substantially higherrevenue receipts mainly on account of taxrevenue, with non-tax revenue registeringa marginal growth. The growth in taxrevenue was suppor ted by buoyantcollections of corporation tax and

41

customs duties. The growth in aggregateexpenditure decelerated mainly onaccount of lower capital expenditure,particularly defence, and deceleration inrevenue expenditure. On the whole, therevenue deficit registered a marginalgrowth of 2.0 per cent during April-June2005 over its level in the correspondingperiod of the previous year. The grossfiscal deficit (GFD) increased by 30.8 percent as compared with an increase of 8.0per cent during April-June 2004 reflectingthe impact of the discontinuance of thedebt swap scheme from 2005-06. TheGFD, however, showed a decline duringApril-June 2005 over its level during April-June 2004, when adjusted for debt swapproceeds.

II.24 Gross market borrowings during2005-06 (net of the MSS) of the Centrewere budgeted at Rs.1,65,467 crore, whilenet market borrowings were placed atRs.1,03,791 crore. During 2005-06 (up toAugust 19, 2005), 50.9 per cent of thegross market borrowing programme hasbeen completed as compared with 51.7 percent during the corresponding period of2004-05. The weighted average yield onfresh government borrowings throughdated securities increased from 6.11 percent in 2004-05 to 7.28 per cent during thecurrent year so far (up to August 19, 2005)while the weighted average maturity fellfrom 14.13 years to 14.04 years over thesame period. In addition to normal marketborrowings, the Central Government raisedRs.6,104 crore (face value) under MSS forsterilisation purposes during 2005-06 sofar (up to August 19). Overall, the netresources raised through Governmentsecurities (Centre, States and MSS)amounted to Rs.59,359 crore (face value)during 2005-06 so far as compared withRs.70,307 crore in the correspondingperiod of the previous year.

II.25 As the demand for non-food creditremained strong, scheduled commercialbanks financed the credit demand fromthe commercial sector by restricting theirincremental investments in Governmentand other approved secur it ies toRs.27,942 crore up to August 5, 2005 asagainst an increase of Rs.55,152 crorein the corresponding period of theprevious year. The effective statutoryliquidity ratio (SLR) of the commercialbanks declined to 37.4 per cent of netdemand and time liabilities (NDTL) as onAugust 5, 2005 from 41.7 per cent a yearago but continues to remain above thestatutory minimum of 25 per cent.

II.26 Despite the strong surge indemand for bank credit, monetaryconditions have remained easy during2005-06 so far (up to August 19, 2005)reflecting l iquidity managementoperations by the Reserve Bank.Responding to a widening of the tradedeficit, a marked increase in the demandfor bank credit from the commercialsector and the onset of the Governmentborrowing programme, the Reserve Bankinjected primary liquidity into the system.The absorption of l iquidity throughincrease in balances under the MSS, tillJuly 22, 2005, was more than offset byliquidity released through the unwindingof LAF. In the first week of August 2005,the balances under LAF reverse reposincreased sharply reflecting larger foreignexchange inflows as well as reduction inthe Central Government’s surplus cashbalances. Reserve money expanded ata higher rate than a year ago.Nonetheless, the year-on-year broadmoney (M

3) growth at 14.5 per cent as

on August 5, 2005 was consistent withthe indicative trajectory of 14.5 per centset out in the Annual Policy Statementfor 2005-06. The commercial sector’s

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demand for bank credit remained strong,with year-on-year non-food credit growthof scheduled commercial banks reaching30.2 per cent as on August 5, 2005 ontop of 24.4 per cent a year ago.Disaggregated data available for the firsttwo months show that credit demand isfairly broad-based. In particular, credit toindustry, housing and real estatecontinued to record strong growth. Morerecent information on industrial credit upto June 2005 indicates signif icantincrease in credit to metals and metalproducts, engineering, power and roadsand por ts. However, the continuedupswing in credit demand for housing andreal estate suggests a greater focus oncredit quality. Accordingly, the ReserveBank increased r isk weights onexposures of banks to commercial estateand capital markets from 100 per cent to125 per cent on July 26, 2005.

II.27 Financial markets were largelystable during the first four months of2005-06, even as interest rates edged up.Money market rates were generallyaligned with the reverse repo rate. Yieldson 10-year Government securities edgedup by 43 basis points between end-March2005 and August 19, 2005 reflectingconcerns over the continued rise ininternational crude oil prices as well asliquidity pressures due to sustained creditdemand. With a relatively higher increasein long-term interest rates, there was asteepening of the yield curve. The Indianrupee appreciated vis-à-vis the US dollarby 0.4 per cent between end-March 2005and August 19, 2005, par tly due toexpected revaluation of the Chinesecurrency, which crystallised on July 21,2005.

II.28 The outlook for the Indianeconomy has to reckon global economicactivity which is expected to decelerate

to 4.3 per cent in 2005 from a three-decade peak of 5.1 per cent recorded in2004. There are already signs of aslackening of momentum in the first halfof 2005 in some areas of theindustrialised world. Among developedcountries, growth has been strong in theUS, albeit lower than a year ago. TheEuro zone has exhibited low growth.Among the EMEs, growth has remainedstrong in China and India, whereas inother Asian and Latin American countriesthere has been some loss of pace. Duringthe second quarter of 2005, consumerprice inflation decreased in the US, butremained stable in the Euro zone, Japanand other advanced economies. Inflationin other major emerging markets anddeveloping countries has also shownsome decline during this quarter. The risein oi l pr ices has not yet tr iggeredgeneralised inflationary pressures incontrast to the experience of earlier oilshocks.

II.29 As regards international crude oilpr ices, the outlook remains highlyuncertain with limited scope for enhancedsupplies in the near future, takingaccount of inventor ies, unuti l isedcapacities and gestation periods for newinvestments. The geopolitical factorsseem to continue to be critical. While theglobal economy is coping with theseuncertainties in a demonstrably bettermanner than in earlier episodes, theassociated problems are getting complexfor oil-exporting countries in terms ofmanaging the surpluses and difficult foroil-importing countries like India in termsof effect on pr ices, output,competitiveness and indeed, disposableincomes. Risks to global growth alsoarise from the imbalances in the currentaccount of the BoP, the fiscal imbalances,hedge fund activity, elevated asset prices

43

and the excessive leveraging in someadvanced economies. The current macro-policy framework of most emergingeconomies has imparted noteworthyresil ience, but heightened globaluncertainties do demand close attentionto elements of the recently accentuateddisequilibria.

II.30 In this context, a recentdevelopment with important consequencesfor the global economy is the decision bythe Chinese authorities to move away fromthe peg to the US dollar to a managedfloating exchange rate regime linked to abasket of currencies, with an initialappreciation of the renminbi (RMB) by 2.1per cent against the US dollar. In thesubsequent period up to August 19, 2005,the yuan has moved in a narrow range of8.0976-8.1127 RMB per US dollar. Thenature, extent and intensity ofmanagement of the exchange rate is yetto be revealed and the associatedadministrative measures by the authoritieswould have to be watched to determine theimpact of these changes on the globaleconomy. Of particular significance wouldbe the ongoing responses of the domesticfinancial as well as real sectors in Chinato the new foreign exchange policy. As percurrent indications, the impact on India isassessed to be marginally positive on tradeaccount, neutral on current account, andsomewhat uncertain on capital flows butis unlikely to be negative for India, thoughthe capital flows could be potentiallyvolatile on the global front.

II.31 The domestic factors, which aremore relevant for India, continue to beposit ive. The performance of theindustrial sector is strengthening and theindicators of growth in services areposit ive. The business expectationsurveys also point to cont inued

optimism. While the onset of monsoonwas delayed, it has progressed wellsubsequently, but uncertainties remainon its progress during the season andconsequently its impact on agriculturaloutput. During the current year so far,the underlying inflationary pressuresappear to have been contained andinflationary expectations maintained, asant ic ipated. On balance, thoughuncer tainties and supply constraintsremain, the domestic growth impulsesappear to have been reinforced in thefirst quarter.

II.32 Given the volatility in the inflationrate during 2004-05, there is a need toconsolidate the gains obtained in recentyears from reining in inf lat ionaryexpectations. While sustained efforts overtime have helped to build confidence inprice stability, inflationary expectationscan turn adverse in a relatively short timeif noticeable adverse movements inprices take place. Credible commitmentof policy to fight inflation is critical to stoptranslation of higher oil prices into wage-price spirals. In addition, the internationalprices of non-oil primary commoditiesmay continue to remain firm. On thedomestic front, the manoeuvrability on oilprices is getting limited and corporateshave a higher probability of gaining theirpricing power with a better industrialoutlook. The pricing pressure, if it wereto occur from the supply side, could getcomplicated by continuing overhang ofexcess domestic liquidity. While theeconomy has the resilience to withstandsupply shocks, the upside risks do exist.As such, the inflationary situation needsto be watched closely to persevere inmaintaining inflation expectations andany complacency on this count couldhave adverse consequences for bothstability and growth.

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II.33 In br ief, although there areseveral global uncertainties, domesticfactors indicate a confidently growingeconomy in a stable environment. Whileglobal factors are gett ing to beincreasingly significant for India, thedomestic factors still dominate and thelatter point to favouring stabil ity tomaintain the growth momentum at thisjuncture while watching inflationarysituation closely to persevere inmaintaining inflation expectations. It is inthis context that key medium-term issueswhich will entrench the conditions for highgrowth with stability merit attention.

REAL SECTOR

Agriculture

II.34 The experience of 2004-05 bringsto the fore, yet again, the raindependence of Indian agriculture. In thiscontext, impar ting stabil i ty to farmincomes assumes critical significance.Globalisation, r ising incomes andurbanisation have brought into focus theneed for increasing diversification andvalue addition in Indian agriculture. Thenew demand patterns as well as the shiftsin consumption warrant a shift of land andother resources to crops with higherpotential for value addition. India hasconsiderable export potential in areassuch as dairying, sericulture, floricultureand horticulture. This segment, besidesenhancing nutr itional and livelihoodstandards, sustains a large number ofagro-industries which hold rich potentialfor non-farm employment.

II.35 In this context, it needs to berecognised that agriculture had a limitedor no direct role to play in providingadditional employment opportunities inthe recent decade. Employment inagriculture remained virtually unchanged

at about 190 million people during the1990s. Concomitantly, the employmentgrowth for the economy, as a whole,decelerated from above two per centduring the 1980s to only 1.1 per cent inthe latter half of the 1990s. With thegrowth rate of working age populationexceeding the overall population growthrate, the unemployment rate couldworsen further if the economic growthenvisaged does not give rise to newactivities that are appropriately labourintensive.

II.36 There is a need to evolve and putin place appropr iate agr iculturaltechnologies and agro-managementpractices to respond to food andnutritional security, poverty alleviation,diversifying market demand, expor toppor tunit ies and environmentalconcerns. It is expected that futureagricultural growth would largely accruefrom improvements in productivity ofdiversified farming systems with regionalspecial isation and sustainablemanagement of natural resources,especially land and water. Effectivelinkages of production systems withmarketing, agro-processing and othervalue added activities would play anincreasingly impor tant role indiversification of agriculture.

II.37 Strengthening the marketing andinfrastructure network as alsoamendment of State Agricultural ProduceMarketing Committee (APMC) Acts inline with the Model Act (2003) in all theStates would go a long way in enhancingmarket efficiency and promoting exportsand processing industry. The Act would,inter alia, facilitate direct sale, promotionof public-pr ivate par tnership in themanagement and development ofagr icultural markets, promotion ofcontract farming, pledge financing,

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trading, export, forward/future tradingand introduction of a negotiablewarehousing receipt system in respect ofagricultural commodities.

II.38 A welcome development in thepast few years is the strong increase inbank credit to the agricultural sector.Credit to the agricultural sector increasedby 35.2 per cent during 2004-05 on topof an increase of 23.2 per cent during theprevious year. It is important that thistrend should continue. In this context, thechanging demand pattern for foodinvolves a reordering of priorities inorganising appropr iate supplyresponses. Supporting policy changesand investment are required to facilitateagricultural diversification and value-addition. In the new growth areas ofagr iculture, the impor tance of postharvest activit ies such as storage,transportation, processing and marketingof non-cereal products increases whichleads to greater l inks betweenagricultural diversification and ruralindustrialisation. Heavy investments needto be made in establishing cold chainsacross the country such as cold storage,transport facilities and the like. In fact,credit requirements would go up due topurchased-input intensive andheterogeneous production cycles of thenew areas of agriculture. This would alsocall for designing innovative schemes andproducts which recognise the differingnature of agri-business and supply chainsfor different products. Newer forms ofcredit assessment and risk managementsystems may also have to be put in place,besides upgrading skills, and ushering inchanges in attitudes and mind-sets.Information technology has to be usedto facilitate transformation in variousprocesses of rural credit. It is hearteningto note that several banks have adopted

policies to direct increased credit toagriculture, but greater attention tostructural, institutional and proceduralsystems may be needed to ensure notonly a sustained growth in credit toagriculture and related activities but alsoprovision of a range of financial services.These steps towards diversification ofagriculture in favour of value addedservices such as those related to the foodprocessing and livestock sectors wouldalso provide stable additional avenues ofemployment generation in the rural sectorand enable these sectors to emerge asthe main source of growth andemployment in rural areas.

II.39 Rural infrastructure - irrigationstructures, agriculture research andextension, transpor t infrastructure,electricity, storage structures - not onlyenhances the productivity of physicalresources but also helps in supply chainmanagement and value addit ion inagriculture. Promotion of micro-irrigationtechnology (comprising drip and sprinklerirrigation) on a large scale deservespriority, particularly in view of the factthat water use eff iciency in Indianagriculture is one of the lowest in theworld. The approach to the developmentof the rural infrastructure would need tostress the impor tance of watermanagement, the criticality of assuredpower supply, high quality of inputs andr isk mit igation strategies includingcushioning the possible adverse impactof tariff rationalisation under the WTO.

Industry

II.40 The recovery in the industrialsector which set in during 2002-03 hassteadily become entrenched and diffused.The overall investment climate during2004-05 was buoyant. A significant

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investment revival is suggested by the verysubstantial increase in investmentintentions registered in 2003-04 and furtherdoubling in 2004-05. Robust export growthreflects the growing competitiveness ofIndian industry. Strong corporateprofitability in the past few quarters, evenin an environment of heightenedcompetitiveness, suggests that the effortsby the Indian industry to restructure itselfare paying off. Continuing strong growthin non-food credit and in imports of capitalgoods and buoyant capital markets indicatethat industry is likely to remain buoyant in2005-06. The congenial policy regime inregard to mergers and acquisitionsincluding the liberalisation of policies inregard to direct investment abroad hasencouraged consolidation of Indianindustry and enabled the reaping of thebenefits of economies of scale. This hasimparted a high degree of competitivenessto Indian industry. In view of the enhancedexternal as well as internal competition,fur ther consolidation through scaleeconomies is likely to remain an importantdriver of industrial growth in the future. Itis, therefore, critical that the currentupsurge in the industry is nurtured in orderfor India to realise its growth potential.

II.41 In this context, there are a hostof infrastructural bottlenecks which couldimpinge upon competitiveness and thesupply elasticities to meet the emergingglobal and domestic demand. Thesubdued performance of theinfrastructure sector, especially that ofcrude petroleum and petroleum refineryproducts, is an issue of concern, giventhe sector’s strong forward and backwardlinkages in the economy. The increasingdemand-supply gap in the availability ofpower is becoming the most critical issuein the future of India’s economicdevelopment. Inadequate powergeneration capacity, lack of optimum

utilisation of the existing generationcapacity, insuff icient inter-regionaltransmission l inks, inadequate andageing sub-transmission and distributionnetwork, slow pace of rural electrificationand inefficient use of electricity by theend consumer have exacerbated theabsolute shortages. In the recent period,shortage of coal and gas has emergedas a ser ious constraint on powergeneration with the supply of both fuelsfalling far short of demand. A number ofthermal plants are reported to be runningwith critical coal stocks of less than aweek, with adverse impact on the plantload factor. Shor tages of gas werereflected in long hours of load sheddingin Maharashtra in May 2005. Imports ofcoal and gas are hampered by the sharpsurge in international prices of thesecommodities. Continuing problems in thepower sector pricing policy suggest anurgent need of reforms to ensurepayment security. The untapped hydroelectricity sources have to be exploredto generate inexpensive electr icity.Besides, there is a need to considergeneration through nuclear energy alsoto meet the expected surge in demandfor energy accompanying the anticipatedgrowth in the medium-term. In any case,having recognised the fact that the Indianeconomy is among the more inefficientusers of energy, highest and urgentpriority needs to be given for energy-saving measures, which could includeappropr iate pr icing pol icies andincentives to invest. In this context, thereis a need for a greater degree of pass-through of higher international crude oilprices to domestic prices. This will alsoenable more efficient use of oil in theeconomy, especially in view of the factthat the rise in international oil pricesappears to have a large permanentcomponent.

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II.42 With growing urbanisation, issuesrelated to urban infrastructure have cometo the forefront. Urban infrastructureconsists of drinking water, sanitation,sewage systems, electricity and gasdistribution, urban transport and primaryhealth services. At present, investmentin urban infrastructure is hampered bythe fact that local governments are notyet creditworthy and urban infrastructureprojects are, therefore, not found to becommercial ly viable. Strengthenedplanning and better coordination betweenvar ious agencies entrusted withmaintenance of urban infrastructurewould have a positive impact on theoverall productivity of economic activityin cit ies. Limitations of urbaninfrastructure were evident during therecent heavy rains in Mumbai and restof Maharashtra during the last week ofJuly 2005. Given the fact that there is aheavy concentration of economic activityin large cities, weak infrastructuralfacilities impede the growth of large cities.It is, therefore, of utmost importance thatthe quality of urban infrastructure in thelarge cities is improved significantly soas to maintain and accelerate themomentum of economic growth andproductivity enhancement. For urbanisingeconomies like India to replicate theexperience of developed countries in theprovision of urban infrastructure, it isessential that al l aspects of citymanagement, including the fostering ofa professional workforce, arestrengthened. This, in turn, wouldincrease the creditwor thiness of citygovernments and help attract theinvestment necessary for vital urbaninfrastructure projects.

II.43 Small and Medium Enterprises(SMEs) are an important segment in theindustrial spectrum of the country owing

to their contributions to employmentgeneration, value addition and exports.The process of de-reservation has beencarried forward during 2005-06 with afurther de-reservation of 108 items fromexclusive production by SSI units in orderto permit the sector to reap theeconomies of scale and to enhancecompetitiveness. The proposed debtrestructuring mechanism for the SMEsector would improve their financialhealth and also protect them from theincidence of sickness. In this context, anoteworthy development is the passingof the Credit Information Companies(Regulation) Act, 2005 by the Parliament.This Act is expected to encourage settingup of credit information companies and,thereby improve exchange of informationon credit histories of the borrowers and,with appropriate r isk assessmenttechniques in place, should lowertransaction costs of the banks. In turn,this is likely to lead to an increase in banklending to SMEs while, at the same time,it is expected that the risk premiumembedded in interest rates charged toSMEs will be reduced.

II.44 The delay in implementation ofseveral central sector projects needscareful monitor ing. Whi le the costoverrun for delayed projects as apercentage of original cost declined from51.8 per cent in March 2004 to 45.2 percent in March 2005, the number ofdelayed projects increased from 112 to125. Procedural bottlenecks and otherproblems relating to allocation of fundsand acquisition of land continue to deterthe implementation of majority of theprojects, par ticular ly in the railwaysector. A reduction of 10 per cent in thecost overrun of delayed projects wouldyield substantial savings of aroundRs.2,500 crore.

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Services

II.45 The services sector remains thegrowth driver of the economy, with acontribution of more than 57 per cent ofGDP. India ranked 18th among the world’sleading exporters of services with a shareof 1.3 per cent in world exports. Theservices sector is expected to benefitfrom the ongoing liberalisation of theforeign investment regime into the sector.Software and the ITES-BPO sectors haverecorded an exponential growth in recentyears. The continued buoyancy in thissector is sustainable in the medium termin view of enabling policy developments,encouraging investment cl imate,improvement in business expectations,affordable labour force, talentedtechnological manpower, time zoneadvantages, improvedtelecommunication facilities and aboveall, a low cost destination for outsourcing.India’s strengths in legal and contractualobligations, apart from a large scientificand technological talent pool, need to beeffectively explored. The ITES sector islabour intensive and holds promises ofhigher employment. To improveinternational confidence and realise thefull potential of the software and servicessector, added emphasis may bewarranted in regard to infrastructure aswell as in the implementation of strongsecurity solutions.

FISCAL POLICY

II.46 Consolidation of CentralGovernment finances so as to achievethe targets set under the FRBM by 2008-09 is the goal of f iscal policy,notwithstanding the ‘pause’ that has beenset during 2005-06. Since 2002-03,Central Government f inances haverecorded a progressive reduction in keydeficit indicators. This has been, inter

alia, enabled by attempts to increase thetax base which is reflected in a sustainedincrease in tax/GDP ratio from 8.8 percent in 2002-03 to 9.9 per cent in 2004-05 and an expected 10.6 per cent in2005-06. Moreover, the recovery ineconomic activity, especially in theindustrial sector, has also enabled animprovement in the tax/GDP ratio andCentral Government finances. Againstthis backdrop, with the GFD/GDP ratioat 4.1 per cent in 2004-05 (provisionalaccounts), the FRBM target of 3.0 percent by 2008-09 appears to be withinstr iking distance. However, with therevenue deficit at 2.6 per cent in 2004-05, the elimination of the revenue deficitby 2008-09 will prove to be more difficult.Achieving this target requires continuedfocused action on containingexpenditures, increase in tax revenuesand reduction in tax exemptions.Revenue augmentation would criticallydepend upon improvement in tax/GDPratio as non-tax revenue is set to declinein the coming years. With the accelerationin overall economic growth that is beingobserved currently, renewed efforts ontax compliance should yield beneficialresults. This assumes further urgency inthe context of the higher devolution of taxrevenues by the Centre to the StateGovernments as recommended by theTwelfth Finance Commission (TFC). Non-debt capital receipts are also slated todecline under the TFC’s scheme of debtwrite-off to be awarded to States on thebasis of reduction of their revenuedeficits. Discontinuance of the practiceof treating disinvestment proceeds asbudgetary receipts will also reduce non-debt capital receipts. Overall, despite therecent improvements in the fiscal positionof the Central Government, the effort inachieving fiscal consolidation will have tocontinue.

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II.47 Achievement of the FRBM targetof revenue deficit at zero per cent of GDPwil l free up resources for publicinvestment which will crowd-in privateinvestment. Hence, in addition to effortsto improve revenues, expendituremanagement centres around theenhancement of the effectiveness of thedelivery mechanism for public services.The phasing out of the Centre fromintermediation of States’ borrowings, asrecommended by the TFC, would providesome space for the Central Governmentto undertake larger capital outlay. Further,the Government’s proposal to announcean ‘outcome budget’ which evaluatesprojects in terms of outcomes rather thanoutlays will enable an improvement in thequality of investment.

II.48 The f iscal scenar io is alsoconditioned by the prevailing globaluncertainties in respect of crude oil pricesand capital flows. Spikes in crude oilprices could result in increased fiscalburden in terms of duty concessions,larger petroleum subsidies or lowerdividends from oil PSEs. Furthermore,holding back the pass-through ofinternational prices to domestic pricesinvolves quasi-fiscal costs which couldeventually turn into a binding constraintfor the fiscal authority.

II.49 The fiscal position of the Statesduring 2005-06 would, to a large extent,be shaped by the recommendations ofthe TFC and the implementation of ValueAdded Tax (VAT). Another importantdevelopment relates to enactment ofFiscal Responsibility Legislation (FRL) byseveral States and proposals to enactlegislation by some others. The UnionGovernment has accepted the majorrecommendations of the TFC and hasincorporated them in the Union Budget,2005-06. An analysis of budget

documents of the State Governmentsreveals that many of them have notfactored in the TFC’s recommendationspertaining to resource devolution. Mostof the States have switched over to a VATregime on the basis of recommendationsof the Empowered Committee of StateFinance Ministers (Chairman: Dr. AsimKumar Dasgupta). The VAT system wouldeliminate the problems of cascading taxburden due to double taxation ofcommodities as well as multiplicity oftaxes through provision of input tax creditand abolition of other related indirecttaxes. It is also expected to enhancetransparency, promote compliance andlead to higher revenue mobilisation. Whilethe implications of introduction of VAT onStates’ resource generation are yet toemerge, the experience of Haryana - thefirst State to introduce VAT in April 2003- has been encouraging from the point ofview of revenue generation. In thiscontext, there may be a mer it inextending the VAT principles to tax theconsumption of almost all goods andservices in the economy.

II.50 The f iscal posit ion of StateGovernments for 2005-06 would continueto undergo correction in terms of keydeficit indicators through containment ofnon-interest revenue expenditure.Accordingly, fiscal empowerment toaugment resource mobilisation from non-tax revenues through appropriate usercharges, cost recovery from social andeconomic services and restructuring ofState PSUs assumes impor tance.Improvement in State finances will enablethe States to step up their expenditureson education and health with a beneficialimpact on the quality of life and thecountry’s ranking in terms of the HumanDevelopment Index. In the recent years,exports of services such as software and

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ITES-BPO services have recorded stronggrowth. For this growth momentum to bemaintained, it is necessary that publicexpenditure on education should reverseits declining trend: total expenditure bythe State Governments on education isbudgeted to decline from 2.5 per cent ofGDP in 2003-04 to 2.3 per cent in 2005-06. Moreover, given the demographicprofile, the demand for education isslated to increase further. Accordingly,the improvement in State finances willenable the States to increase theirexpenditure on education and othersocial services and thereby improve thequality of overall social infrastructure sothat India can realise its potential.

II.51 The health of public finances willbenefit vastly from improvements in costrecovery of various public services andrationalisation of subsidies. At present,user charges are inadequate for tworeasons. First, it is perceived that theservices are provided by the Governmentand, therefore, do not have to be paidfor. Second, with the quality of the servicebeing poor, the public is loath to payhigher charges. The attainment of higherefficiency in the provision of services canprogressively lead to lower charges.Better cost recoveries will not onlyimprove public finances but will alsocreate enabling grounds for financialsector development so that each activitybecomes financially viable.

EXTERNAL SECTOR

II.52 Var ious reforms in the tradepolicy regime have unlockedentrepreneurial energies, stepped upproductivity gains and improvedcompetitiveness and access to overseasmarkets. India’s merchandise exportshave been rising at a rate of over 20 percent per annum, in US dollar terms,

during 2002-05. As a result, the seculardecline in India’s share in world exportsfrom two per cent in 1950 to 0.5 per centin the 1980s has been reversed. Thisshare began rising in the 1990s and iscurrently at 0.8 per cent. These positivedevelopments in the external sectorprovide the environment of pursuing afurther rationalisation of tariffs with a viewtowards moving to a single, uniform rateon impor ts, say 10 per cent, andsimplifying all customs proceduresstrictly in line with best global practices.This should help to improve competition,exports and domestic consumers. Thecurrent external environment, includingthe level of the foreign exchangereserves, enables such a move to bemade with little or no downside risks.

II.53 While the recent trend in importsmay continue to persist in the face of highand volatile crude oil prices and the largeincrease in domestic demand, an intrinsiclink between merchandise imports andexpor ts has emerged and becomeentrenched. The large expansion inimports is also spurring vigorous exportgrowth. Given the recent experience,especially the fact that remittances fromIndians employed abroad seem to haveacquired a permanent character, thecurrent level of the trade deficit appearsto be manageable at this stage andappears to be consistent with India’sgrowth aspirations.

II.54 In regard to capital flows, Indiahas adopted a policy of activemanagement of the capital account. Thecompositional shifts in the capital accounttowards non-debt flows since the early1990s have been consistent with thepolicy framework, imparting stability tothe balance of payments. The substitutionof debt by non-debt flows also gives roomfor manoeuvre since debt levels,

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par ticular ly external commercialborrowings, have been moderate. Thereis also the cushion available from theforeign exchange reserves. Since non-debt creating flows are dominating, theemphasis is on encouraging inflowsthrough foreign direct investment andenhancing the quality of portfolio flowsby strict adherence to what may bedescr ibed as ‘Know Your Investor’principle. Prudential regulations overfinancial intermediaries, especially overbanks, in respect of their foreignexchange exposures and transactionsare a dynamic component ofmanagement of the capital account aswell as financial supervision.

II.55 India has made significantprogress in financial liberalisation since theinstitution of financial sector reforms in1992 and this has been recognisedinternationally. India has chosen to proceedcautiously and in a gradual manner,calibrating the pace of capital accountliberalisation with underlyingmacroeconomic developments, the stateof readiness of the domestic financialsystem and the dynamics of internationalfinancial markets. Unlike in the case oftrade integration, where benefits to allcountries are demonstrable, in the case offinancial integration, a “threshold” in termsof preparedness and resilience of theeconomy is important for a country to getfull benefits. A judgmental view needs tobe taken whether and when a country hasreached the threshold and the financialintegration should be approachedcautiously, preferably within the frameworkof a plausible roadmap that is drawn up byembodying the country-specific contextand institutional features. The experienceso far has shown that the Indian approachto financial integration has stood the testof time.

II.56 The optimism generated by therecent gains in macroeconomicperformance warrants a balancedconsideration of fur ther f inancialliberalisation. At this stage, the optimismgenerated by impressive macroeconomicperformance accompanied with stabilityhas given r ise to pressures forsignificantly accelerating the pace ofexternal financial liberalisation. It isessential to take into account the risksassociated with it while resetting anaccelerated pace of a gradualistapproach. The recent experience in manycountr ies shows that per iods ofimpressive macroeconomic performancegenerate pressures for speedier financialliberalisation since everyone appears tobe a gainer from further liberalisation, butthe costs of instability that may begenerated in the process are borne bythe country, the government and thepoorer sections. Avoiding cr ises isultimately a national responsibility. Theapproach to managing the externalsector, the choice of instruments and thetiming and sequencing of policies arematters of informed judgment, given theimponderables.

II.57 The overall approach to themanagement of India’s foreign exchangereserves in recent years reflects thechanging composition of the balance ofpayments and the ‘ l iquidity r isks’associated with different types of flowsand other requirements. The policy forreserve management is thus judiciouslybuilt upon a host of identifiable factorsand other contingencies. Taking thesefactors into account, India’s foreignexchange reserves continue to be at acomfortable level and consistent with therate of growth, the share of the externalsector in the economy and the size ofrisk-adjusted capital flows.

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FINANCIAL SECTOR

II.58 With increasing financial sectorliberalisation and emergence of financialconglomerates, financial sector stabilityhas emerged as a key objective of theReserve Bank. In this context, the recentemphasis in the regulatory framework inIndia on ensuring good governancethrough “fit and proper” owners, directorsand senior managers of the banksinfuses a qualitative dimension to theconventional discharge of f inancialregulation through prescribing prudentialnorms and encouraging marketdiscipline. In totality, however, thesemeasures interact to produce a positiveimpact on the overall efficiency andstability of the banking system in India.There has been a marked improvementin capital adequacy, asset quality and theprofitabil i ty of the banking system.Commercial banks in India will startimplementing Basel II with effect fromMarch 31, 2007. They will adopt theStandardised Approach for credit risk andthe Basic Indicator Approach foroperational risk, initially. After adequateskills are developed, both at the banksand also at supervisory levels, somebanks may be allowed to migrate to theInternal Rating Based Approach. Bankshave also been advised to formulate andoperationalise the Capital AdequacyAssessment Process as required underPillar II of the New Framework.

II.59 Implementation of Basel II willinitially require more capital for banks inIndia in view of the fact that operationalrisk is not captured under Basel I, andthe capital charge for market risk was notprescribed until recently. Consequently,banks are explor ing all avenues formeeting the capital requirements underBasel II.

II.60 Above all, capacity building, bothin banks and the regulatory bodies is aserious challenge, especially with regardto adoption of the advanced approaches.The Reserve Bank has accordinglyinitiated supervisory capacity-buildingmeasures to identify the gaps and toassess as well as quantify the extent ofadditional capital which may be requiredto be maintained by such banks.

II.61 Compared to other developingcountries, the extent of rating penetrationin India has been increasing every yearand a large number of capital issues ofcompanies have been rated. However,since rating is of issues and not ofissuers, it is likely to result, in effect, inapplication of only Basel I standards forcredit r isks in respect of non-retailexposures. While Basel II provides somescope to extend the rating of issues toissuers, this would only be anapproximation and it would be necessaryfor the system to move to rating ofissuers. Encouraging rating of issuerswould be essential in this regard. In thiscontext, current non-availabil i ty ofacceptable and qualitative historical datarelevant to ratings, along with the relatedcosts involved in building up andmaintaining the requisite database, doesinfluence the pace of migration to theadvanced approaches available underBasel II.

II.62 In the current scenario, banks areconstantly pushing the frontiers of riskmanagement. Compulsions arising out ofincreasing competition, as well as agencyproblems between management, ownersand other stakeholders are inducingbanks to look at newer avenues toaugment revenues, while trimming costs.Consolidation, competition and r iskmanagement are no doubt critical to thefuture of banking but governance and

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financial inclusion are also likely toemerge as the key issues for a countrylike India, at this stage of socio-economicdevelopment.

MONETARY POLICY

II.63 The recent trends in creditdemand are encouraging although thereis a recognition of a greater need toensure credit quality. It is important thatthe sharp increase in credit flow to therural sector witnessed during the past twoyears is maintained while reducingintermediation cost so that borrowingcosts also come down. The thrust of thecurrent strategy adopted by the ReserveBank to increase the flow of rural credit ison enhancing credit delivery in a regimeof reasonable credit prices within theexisting legal and institutional constraints.It is noteworthy that the share of small andmarginal farmers in credit disbursed bypublic sector banks under the SpecialAgricultural Credit Plans has increasedfrom 26.7 per cent during 2002-03 to 31.9per cent during 2004-05. In order tofurther strengthen these efforts, there is,first, a need for legal and institutionalchanges relating to governance,regulation and functioning of ruralcooperative structure and Regional RuralBanks (RRBs) which would have to be,as or iginally envisaged, cr it icalinstruments for rural credit. The changeswarranted in cooperatives as well asRRBs involve deep commitment of StateGovernments and have a significantbearing on the political economy. Second,the overhang problems of non-performingloans and erosion of deposits in bothcooperatives and RRBs have an inevitablefiscal impact of any scheme ofrecapitalisation. The current accelerationin credit delivery can be sustained in the

medium term, if such fiscal support fromStates and Centre is firmly put in placewhile reviving or reorganising ruralcooperative structure and RRBs, providedsound legal and policy frameworks arefirmly put in place as a pre-condition. Inthe meantime, there is need to considerinitiatives, as mutually agreed betweenthe Reserve Bank and select States, tostrengthen or revive, as appropriate, ruralcredit institutions while adhering to basicprudential requirements. Third, there is aneed to foster credit culture to makeenhanced rural credit a lastingphenomenon. Fourth, on the critical issueof r isk mitigation, it is held thatexperiments with crop or credit insurancein India have not been very satisfactoryso far. If some elements of insurance areab initio not viable, extending creditbecomes risky and hence constrained.Finally, there is merit in considering acomprehensive public policy on riskmanagement in agriculture, not only as ameans of relief for distressed farmers butas an ingredient for more efficientcommercialised agriculture.

II.64 The programme of linking self-help groups with the banking system hasemerged as the major micro-financeprogramme in the country. It is in thiscontext that the Reserve Bank has beendeveloping a congenial environment fornon-governmental organisations engagedin micro-finance activities. Banks arebeing encouraged to adopt the agencymodel by using the infrastructure of civilsociety organisations, rural kiosks andvillage knowledge centres for providingcredit support to rural and farm sectorsand appointment of micro-financeinstitutions as banking correspondents.

II.65 The small scale industries sectorplays a very impor tant role in the

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development of the economy. The ReserveBank is reviewing all its existing guidelineson financing small scale sector, debtrestructuring, and nursing of sick units witha view to rationalising, consolidating andliberalising them. In view of the fastchanging market conditions and increasingcompetitiveness, there is an urgent needto upgrade the technology of small scaleindustries and facilitate their graduation tothe medium enterprise sector. A simplifieddebt restructur ing and rehabilitationmechanism is being considered for thesector.

II.66 Although there has beenexpansion, greater competition anddiversification of ownership of banksleading to both enhanced efficiency andsystemic resilience in the banking sector,there are legitimate concerns in regardto the banking practices that tend toexclude rather than attract vast sectionsof population, in particular pensioners,self-employed and those employed in theunorganised sector. Against thisbackground, the Reserve Bank willimplement policies to encourage bankswhich provide extensive services whiledisincentivising those which are notresponsive to the banking needs of thecommunity, including the underprivileged.The nature, scope and cost of serviceswill be monitored to assess whether thereis any denial, implicit or explicit, of basicbanking services to the common person.

II.67 Liberalisation and enhancedcompetition accord immense benefits,but exper ience has shown thatconsumers’ interests are not necessarilyaccorded ful l protection and theirgrievances are not properly attended to.Several representations are beingreceived in regard to recent trends oflevying unreasonably high service/usercharges and enhancement of user

charges without proper and pr iorintimation. These issues have to beaddressed keeping in view the merits oftransparency, the need for avoidance ofexcessive charges and infirmities incontracts between vastly unequal parties.

II.68 In recent years, there has beensome convergence in the conduct ofmonetary policy worldwide. Currently,there are striking similarities in the toolsthat monetary authorities employ toassess macroeconomic developmentsand the formation of expectations. Theinstitutional architectures have begun todisplay several commonalit ies. Thecommunication strategies and, thereby,public accountability are in the forefrontin all central banks with progressivelyincreasing globalisation of financialmarkets and emphasis on central bankautonomy. There is also greater universalrecognition of the trade-offs confrontingmonetary policy decisions. At the sametime, the challenges facing monetaryauthorities have become sharper. Theheightened uncertainty surrounding theconduct of monetary policy has madeinterpretation of macroeconomic andfinancial data difficult. Uncertainty ismore easily transmitted across the worldthan before through the ‘confidence’channel, forcing the monetary authoritiesto contend with the contagion fromshocks. Since the 1990s, considerationsof financial stability have, therefore,assumed an increasing importance inmonetary policy across the globe.

II.69 Notwithstanding these tendenciestowards globalisation, the conduct ofmonetary policy continues to depend oncountry-specific factors such as themacroeconomic structure of the economyand its institutional setting, the degree ofopenness of the economy, the stage ofdevelopment of financial markets, payment

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and settlement systems and thetechnological infrastructure. In India,although there is no explicit mandate forprice stability, the conduct of monetarypolicy has evolved around the objectivesof maintaining price stability and ensuringadequate flow of credit to the productivesectors of the economy for sustainingoverall economic growth. The relativeemphasis between price stability andgrowth has varied depending upon theunderlying macroeconomic conditions. Inessence, monetary policy in India strivesfor a judicious balance between pricestability and growth. The democraticprocesses in India work in favour of pricestability which, in some ways, amounts toan informal mandate to the central bankfor maintaining an acceptable level ofinflation. This framework has also beensuccessful in ensuring financial stability inIndia through a decade and a half whenfrequent visits of financial crises led todebilitating losses in growth and welfarein large parts of the emerging marketeconomies.

II.70 The conduct of monetary policy isgetting increasingly sophisticated andforward looking, warranting a continuousupgradation of monitoring scan andtechnical skills. Flexibility and timeliness inpolicy response coupled with transparencyand accountability hold the key to furtherenhancing credibility. Above all, themonetary authority has to addressdilemmas which exert conflicting pulls atevery stage. These issues have come tothe fore in the conduct of monetary policyby the Reserve Bank in recent years. TheReserve Bank will continue to takenecessary measures in response to theevolving situation to meet its price stabilityobjective while maintaining financialstability and ensuring appropriate liquidityto meet credit growth and suppor t

investment and export demand in theeconomy.

II.71 With a view to fur therstrengthening the consultative process inmonetary policy, the Reserve Bank, in July2005, set up a Technical AdvisoryCommittee on Monetary Policy withexternal experts in the areas of monetaryeconomics, central banking, financialmarkets and public finance. TheCommittee, which would meet at leastonce in a quar ter, will reviewmacroeconomic and monetarydevelopments and advise the ReserveBank on the stance of monetary policy. Theviews of the Advisory Committee would bediscussed in the following meeting of theCommittee of the Central Board (CCB) ofthe Reserve Bank. Concomitantly, theReserve Bank decided that in addition toa Mid-term Review of the Annual PolicyStatement in October, there will be a FirstQuarter Review of Part I of the Statementin July and a Third Quarter Review inJanuary. The proposed quarterly reviewsof monetary policy provide the opportunityfor structured communication with marketson a more frequent basis while retainingthe flexibility to take specific measures asthe evolving circumstances warrant. TheFirst Quarter Review – the first in the series– was released on July 26, 2005.

II.72 In sum, it is clear that prospectsfor economic growth are strong, whileinflation has been contained so far.Maintaining macroeconomic and financialstability in an environment of sustainedhigh growth of the economy in the futurewould, however, depend critically onpolicies relating to oil pr ices,diversification of agriculture, improvementin urban infrastructure, determinedmeasures for fiscal consolidation and,above all, on the continuation of thepositive investment climate in the country.

ASSESSMENT AND PROSPECTS