Monetary Policy Report - October 2021

Published under Section 45ZM of the Reserve Bank of India Act, 1934 Monetary Policy Report OCTOBER 2021 Reserve Bank of India MumbaiContents Chapter I: Macroeconomic Outlook 1 I.1 : Key Developments since the April 2021 MPR 1 I.2 : The Outlook for Inflation 5 I.3 : The Outlook for Growth 7 I.4 : Balance of Risks 9 I.5 : Conclusion 13 Box I.1: Capital Flow and Exchange Rate Shocks: Macroeconomic Implications 11 Chapter II: Prices and Costs 14 II.1 : Consumer Prices 15 II.2 : Drivers of Inflation 17 II.3 : Costs 31 II.4 : Conclusion 34 Box II.1 : News Sentiment-based Analysis of Food Inflation Outlook 21 Box II.2 : CPI-WPI Inflation Post-Lockdown: Long-run Cointegration and Short-run Error Correction 30 Chapter III: Demand and Output 35 III.1 : Aggregate Demand 36 III.2 : Aggregate Supply 48 III.3 : Conclusion 56 Box III.1: Tracking Macroeconomic Activity using Digital Payments Data 38 Chapter IV: Financial Markets and Liquidity Conditions 57 IV.1 : Domestic Financial Markets 57 IV.2 : Monetary Policy Transmission 70 IV.3 : Liquidity Conditions and the Operating Procedure of Monetary Policy 76 IV.4 : Conclusion 82 Box IV.1: External Benchmark Regime and Transmission to Lending Rates 71 Box IV.2: Determinants of Forward Premia – A Macro-Finance Approach 78 Chapter V: External Environment 83 V.1 : Global Economic Conditions 83 V.2 : Commodity Prices and Inflation 89 V.3 : Monetary Policy Stance 94 V.4 : Global Financial Markets 97 V.5 : Conclusion 99 Box V.1: Global Semiconductor Shortage: Opportunities and Challenges 87 Box V.2: Global Commodity Prices: Is a Super Cycle Forming? 91 iABBREVIATIONS AEs - Advanced Economies CII - Confederation of Indian Industry AEs - Advance Estimates CIP - Covered Interest Parity AIDC - Agriculture Infrastructure and CLI - Composite Leading Indicator Development Cess CMIE - Centre for Monitoring Indian AIFIs - All India Financial Institutions Economy APP - Asset Purchase Programme COVID-19 - Coronavirus Disease 2019 AR - Autoregressive CP - Commercial Paper ARDL - Autoregressive Distributed Lag CPI - Consumer Price Index ASEAN - Association of Southeast Asian CPI-AL - Consumer Price Index for Nations Agricultural Labourers ATM - Automated Teller Machine CPI-IW - Consumer Price Index for Industrial Workers BE - Budget Estimates CPI-RL - Consumer Price Index for Rural BIC - Bayesian Information Criterion Labourers BIES - Business Inflation Expectations CRR - Cash Reserve Ratio Survey CU - Capacity Utilisation BIS - Bank for International Settlements DCA - Department of Consumer Affairs BoC - Bank of Canada DEH - District as Export Hub BoE - Bank of England DGCA - Directorate General of Civil Aviation BoJ - Bank of Japan DGCI&S - Directorate General of Commercial BP - Band-Pass Intelligence and Statistics bps - Basis Points DII - Domestic Institutional Investor BRICS - Brazil, Russia, India, China and EBIT - Earnings Before Interest and Taxes South Africa ECB - European Central Bank BSE - Bombay Stock Exchange ECI - Eight Core Industries CAD$ - Canadian Dollar ECLGS - Emergency Credit Line Guarantee CCIL - Clearing Corporation of India Scheme Limited EMDEs - Emerging Market and Developing CD - Certificate of Deposit Economies CDS - Credit Default Swap EMEs - Emerging Market Economies CGA - Controller General of Accounts EPFO - Employees’ Provident Fund CI - Confidence Interval Organisation CiC - Currency in Circulation EU - European Union iiiiiiMonetary Policy Report October 2021 EXIM - Export-Import Bank of India H2 - Second Half of the Financial Year (October-March) FAO - Food and Agriculture Organization HICP - Harmonised Index of Consumer FBIL - Financial Benchmarks India Pvt. Ltd Prices FDI - Foreign Direct Investment HSD - High Speed Diesel FE - Final Estimates ICICI - Industrial Credit and Investment Fed - Federal Reserve Corporation of India FICCI - Federation of Indian Chambers of ICR - Interest Coverage Ratio Commerce and Industry IIP - Index of Industrial Production FIMMDA - Fixed Income Money Market and Derivatives Association of India IMD - India Meteorological Department FIs - Financial Institutions IMF - International Monetary Fund FL - Family Labour INR - Indian Rupee FOMC - Federal Open Market Committee IOCL - Indian Oil Corporation Limited FPI - Foreign Portfolio Investment IPO - Initial Public Offering FRE - First Revised Estimate IRDAI - Insurance Regulatory and FRL - Full Reservoir Level Development Authority of India F-TRAC - FIMMDA Trade Reporting and IRFCL - International Reserves and Foreign Confirmation System Currency Liquidity FY - Financial Year IT - Information Technology GDP - Gross Domestic Product LAF - Liquidity Adjustment Facility GFCE - Government Final Consumption LCR - Liquidity Coverage Ratio Expenditure LM - Lagrange Multiplier GFCF - Gross Fixed Capital Formation GFD - Gross Fiscal Deficit LPA - Long Period Average GMM - Generalised Method of Moments LPG - Liquefied Petroleum Gas GNDI - Gross National Disposable Income LPR - Loan Prime Rate GoI - Government of India LTROs - Long Term Repo Operations G-SAP - Government Securities Acquisition MAEQ - Maximum Admissible Export Quota Programme M-cap - Market Capitalisation G-Secs - Government Securities MCLR - Marginal Cost of Funds Based GST - Goods and Services Tax Lending Rate GVA - Gross Value Added MFs - Mutual Funds H1 - First Half of the Financial Year MGNREGA - Mahatma Gandhi National Rural (April-September) Employment Guarantee Act iivvAbbreviations MMRP - Modified Mixed Reference Period NSO - National Statistical Office MOAFW - Ministry of Agriculture and Farmers’ NSS - Net Sentiment Score Welfare NSSO - National Sample Survey Office MoH&FW - Ministry of Health and Family ODOP - One District One Product Welfare OECD - Organisation for Economic Co- m-o-m - Month-on-Month operation and Development MOSPI - Ministry of Statistics and OMO - Open Market Operations Programme Implementation ON RRP - Overnight Reverse Repurchase MPC - Monetary Policy Committee Agreement MPR - Monetary Policy Report OPEC - Organisation of the Petroleum MSCI - Morgan Stanley Capital International Exporting Countries MSEs - Micro and Small Enterprises OTC - Over-the-Counter MSF - Marginal Standing Facility PADO - Public Administration, Defence and Other services MSMEs - Micro, Small and Medium Enterprises PBoC - People’s Bank of China MSP - Minimum Support Price PC - Principal Component NABARD - National Bank for Agriculture and PCE - Personal Consumption Expenditure Rural Development PDS - Public Distribution System NBFCs - Non-Banking Financial Companies PD - Primary Dealer NCAER - National Council of Applied PE - Provisional Estimates Economic Research PEPP - Pandemic Emergency Purchase NDS - Negotiated Dealing System Programme NDTL - Net Demand and Time Liabilities PFCE - Private Final Consumption NEER - Nominal Effective Exchange Rate Expenditure NGNF - Non-Government Non-Financial PIB - Press Information Bureau NHB - National Housing Bank PLI - Production Linked Incentive NIP - National Infrastructure Plan PMGKAY - Pradhan Mantri Garib Kalyan Anna NMEO-OP - National Mission on Edible Oil - Oil Yojana Palm PMI - Purchasing Managers’ Index NMP - National Monetisation Pipeline POL - Petroleum, Oil and Lubricants NPA - Non-Performing Asset POSOCO - Power System Operation NSC - National Savings Certificate Corporation Limited NSDL - National Securities Depository PPAC - Petroleum Planning and Analysis Limited Cell vvMonetary Policy Report October 2021 PRN - Production Weighted Rainfall SPECS - Scheme for Promotion of Manufacturing of Electronic PSB - Public Sector Bank Components and Semiconductors PSU - Public Sector Undertaking T-Bill - Treasury Bill PvB - Private Sector Bank TLTRO - Targeted Long Term Repo Operation Q1 - First Quarter TSMC - Taiwan Semiconductor Q2 - Second Quarter Manufacturing Company Q3 - Third Quarter UK - United Kingdom Q4 - Fourth Quarter UNCTAD - United Nations Conference on Trade q-o-q - Quarter-on-Quarter and Development QPM - Quarterly Projection Model US - United States RBD - Refined Bleached Deodorised US$ - US Dollar RBI - Reserve Bank of India USGS - United States Geological Survey RD - Revenue Deficit VAR - Vector Autoregression REER - Real Effective Exchange Rate VECM - Vector Error Correction Model RHS - Right Hand Side VRRR - Variable Rate Reverse Repo RL - Rural Labourers WAC - Weighted Average Coupon RM - Reserve Money WACR - Weighted Average Call Money Rate SAAR - Seasonally Adjusted Annualised Rate WADR - Weighted Average Discount Rate SCB - Scheduled Commercial Bank WADTDR - Weighted Average Domestic Term SDL - State Development Loan Deposit Rate SEBI - Securities and Exchange Board of WALR - Weighted Average Lending Rate India WAM - Weighted Average Maturity SFB - Small Finance Bank WAR - Weighted Average Rate SIAM - Society of Indian Automobile WEO - World Economic Outlook Manufacturers WMA - Ways and Means Advances SIDBI - Small Industries Development Bank of India WPI - Wholesale Price Index SIP - Systematic Investment Plan WTI - West Texas Intermediate SLF - Special Liquidity Facility WTO - World Trade Organization SLR - Statutory Liquidity Ratio y-o-y - Year-on-Year SLTRO - Special Long-Term Repo Operation YTD - Year to Date vviiI. Macroeconomic Outlook Domestic economic activity is normalising after the ferocious second wave retarded momentum. The outlook remains overcast by the future path of the pandemic; the accelerated pace of vaccination and release of pent-up demand provide an upside to the baseline growth path. Headline inflation has fallen back into the tolerance band and the trajectory is expected to be driven by supply-side factors. A faster resolution of supply chain disruptions, good foodgrains production and effective supply management could cause inflation to undershoot the baseline, contingent on the evolution of the pandemic and the efficacy of vaccines. In the months following the retention of the I.1 Key Developments since the April 2021 MPR inflation target at 4 per cent with a +/- 2 per cent Since the release of the April 2021 Monetary tolerance band around it for the period 2021-26 by Policy Report (MPR), the global macroeconomic the Government of India (GoI) on March 31, 2021, environment has been unsettled by diverging paths the monetary policy framework faced a testing of economies across the world, between advanced challenge from a shock price spike in May 2021. and emerging economies and also among them, In addition to pandemic-induced disruptions that mainly differentiated by vaccine access. This is shaped the trajectory of inflation during the first reflected most vividly in monetary policy actions wave, spillovers from the hardening of commodity and stances, with some of them staying the course prices, especially of crude and edible oil, propelled of remaining accommodative and supporting growth headline inflation above the upper tolerance band. and others pre-emptively tightening monetary policy The episode was short-lived though and inflation has on the assessment that inflation presents a bigger fallen back into the tolerance band. The monetary risk. Decoupling of growth paths and the disconnect policy committee (MPC) decided to look through this in monetary policy responses pose downside risks shock, reading it as supply-driven and transitory. In to the global recovery, which already appears to its meetings in June and August, the MPC maintained be losing steam. Global economic conditions are status quo on the policy rate and committed to also besieged by the resurgence of inflation across remain accommodative as long as it takes to revive the world. Some central banks, mostly in advanced and sustain growth and mitigate the impact of the economies (AEs), have judged the rise in inflation as pandemic on the economy. Developments in the real transitory, while some others, mostly in emerging economy in the first half of 2021-22 have vindicated market economies (EMEs) regard breaches of this stance – shorn of statistical base effects, upper tolerance bands as unacceptable and growth aggregate demand trails below pre-pandemic levels threatening. Financial markets are trying to second- and considerable slack still prevails in the economy, guess the commencement of normalisation. Episodic especially in contact-dependent sectors that faced shifts in risk appetite have rendered equity markets the brunt of the pandemic. In the second quarter of frothy with stretched valuations, with intermittent 2021-22, however, a hesitant recovery is underway, flights into and out of the safety of bonds. Meanwhile, nurtured by the appreciable decline in infections, the EMEs are awash with capital flows and rotations stepping up of the scale and speed of vaccinations, thereof on taper talk and carry trade and currencies and the congenial financial conditions engendered have turned volatile as a result. Several countries by monetary policy. that had unlocked their economies and encouraged 1Monetary Policy Report October 2021 mobility have faced renewed surges of infections weaker than anticipated in the April MPR and from the Delta variant of the virus, which has turned remained below 2019-20 levels. High frequency the evolving global outlook highly uncertain and indicators of activity suggest that the economy may fragile. be pulling out of the second wave’s impact, but uncertainty about the incidence of the third wave Global growth has been supported by strong external makes the outlook fraught with risks. demand on the back of buoyant merchandise trade. The World Trade Organization’s (WTO) goods trade Thus, the pandemic continues to have an barometer hit a high in June 2021 reading. The overwhelming influence on global and domestic 20-point year-on-year (y-o-y) rise in the index reflects macroeconomic conditions. Virus mutations both the strength of the recent trade expansion threaten the progress made through vaccinations and the depth of the pandemic-induced shock and medical responses. Infections keep flaring up in 2020. Worryingly, though, the rate of increase in various geographies, forcing authorities to re- in the index has started to come off, presaging a impose restrictions/lockdowns restraining economic peaking of the upward momentum in world trade. activity. At the same time, greater adaptability, rising Container shortages, increased port turnover time vaccination coverage and continuation of policy and three major shipping alliances controlling much support are working towards mitigating the effects of the supplies have resulted in a jump in freight of new waves of the pandemic. Equal and universal rates putting the sustainability of the global trade vaccination holds the key to a brighter outlook, both expansion at risk. Services trade continues to lag globally and domestically. merchandise trade, with significant contraction in Monetary Policy Committee: April-September 2021 international travel services, although in Q2 some improvement is evident, including through revenge During April-September 2021, the MPC met thrice. tourism, and increase in transport and other goods In the April meeting, the MPC noted that supply related services boosted by demand for goods and side pressures on inflation could persist while freight rates. demand-side pull remains moderate. On the gross domestic product (GDP) growth outlook, the jump in In India, the recovery that was taking hold from the COVID-19 infections in certain parts of the country second half of 2020-21 was disrupted by the second and the associated localised lockdowns were seen wave of COVID-19 in the weeks following the release of the April 2021 MPR. Although the ferocity of the as dampening the demand for contact-intensive second wave was not anticipated, the loss of output services, restraining growth impulses and prolonging was about 40 per cent less than during the first wave, as the return to normalcy. In such an environment, adaptation to pandemic protocols limited restrictions the MPC observed that continued policy support to localised and region-specific containment remained necessary and unanimously voted to keep measures instead of the nation-wide lockdown that the policy repo rate unchanged and to continue with was enforced during the first wave. Nevertheless, the accommodative stance as long as necessary to inflationary pressures became accentuated, as set out sustain growth on a durable basis and mitigate the earlier, with erosion in fiscal positions. Against this impact of COVID-19 on the economy, while ensuring backdrop, the pace of domestic economic activity in that inflation remained within the target going Q1:2021-22 (April-June) turned out to be somewhat forward. 22Chapter I Macroeconomic Outlook In the June 2021 meeting, the MPC observed that the Table I.1: Monetary Policy Committees and Policy rising trajectory of international commodity prices, Rate Voting Patterns especially of crude, together with logistics costs, Country Policy Meetings: April - September 2021 posed upside risks to the inflation outlook with weak Total Meetings Meetings Variation demand conditions tempering the pass-through meetings with full without in policy consensus full rate (basis to core inflation. On the growth outlook, the MPC consensus points) noted that the second wave of COVID-19 had altered Brazil 4 4 0 350 Chile 4 4 0 100 the near-term outlook, and policy support from all Colombia 4 1 3 25 sides – fiscal, monetary and sectoral – was required Czech Republic 4 1 3 125 to nurture recovery and expedite return to normalcy. Hungary 6 6 0 105 India 3 3 0 0 Accordingly, the MPC decided unanimously to Israel 4 2 2 0 maintain status quo on the policy repo rate and Japan 4 0 4 0 South Africa 3 3 0 0 continue with the accommodative stance. Sweden 3 3 0 0 Thailand 4 3 1 0 When the MPC met in August, headline inflation had UK 4 4 0 0 breached the upper threshold for the second month US 4 4 0 0 in succession in June due to strong momentum Sources: Central bank websites. in the May print running across all the major sub- groups. The MPC assessed that the inflationary For the updated projections set out in this Chapter, pressures were largely driven by transitory supply the evolution of key macroeconomic and financial shocks while stressing that it was conscious of its variables over the past six months warrants revisions objective of anchoring inflation expectations. On in the baseline assumptions as set out below growth, the MPC noted that the outlook for aggregate (Table I.2). demand was improving, but it was still weak and there was a large amount of slack in the economy, First, global crude oil prices have hardened with output below its pre-pandemic level. It judged substantially since the April MPR on the back of a that the nascent and hesitant recovery needed to be rebound in demand and regulated production by the nurtured. Accordingly, the MPC decided unanimously Organization of the Petroleum Exporting Countries to keep the policy repo rate unchanged and on a 5 (OPEC) plus. Crude prices initially eased from July to 1 majority to continue with the accommodative 2021 highs on the back of the decision by OPEC stance. plus to increase production by 0.4 million barrels per day on a monthly basis starting August and The MPC’s voting pattern on the policy repo rate the moderation in demand due to renewed surge setting during H1:2021-22 reflected broader in COVID-19 infections. Crude prices, however, unanimity in members’ assessments and hardened again in August-September on supply expectations, mirroring the voting outcomes in a disruptions due to hurricanes and fall in inventories. number of other central banks (Table I.1). Taking into account these developments, crude prices Macroeconomic Outlook (Indian basket) are assumed at US$ 75 per barrel in Chapters II and III analyse the macroeconomic the baseline, 16 per cent above the April 2021 MPR developments during H1:2021-22 (April-September). baseline (Chart I.1). 33Monetary Policy Report October 2021 Table I.2: Baseline Assumptions for Projections Chart I.1: Brent Prices Indicator MPR April 2021 MPR October 2021 Crude Oil US$ 64.6 per barrel US$ 75 per barrel (Indian basket) during 2021-22 during H2:2021-22 Exchange rate `72.6/US$ during `74.3/US$ during 2021-22 H2:2021-22 Monsoon Normal for 2021 1 per cent below long-period average Global growth 5.5 per cent in 2021 6.0 per cent in 2021 4.2 per cent in 2022 4.9 per cent in 2022 Fiscal deficit To remain within BE To remain within BE (per cent of GDP) 2021-22 2021-22 Centre: 6.8 Centre: 6.8 Combined: 10.8 Combined: 10.2 Domestic No major change No major change macroeconomic/ structural Source: Bloomberg. policies during the forecast period Notes: 1. The Indian basket of crude oil represents a derived numeraire 74.3 per US dollar in the baseline as against INR 72.6 comprising sour grade (Oman and Dubai average) and sweet grade (Brent) crude oil. in the April MPR. 2. The exchange rate path assumed here is for the purpose of generating the baseline projections and does not indicate any Third, the strength of global growth and external ‘view’ on the level of the exchange rate. The Reserve Bank is guided by the objective of containing excess volatility in the demand has been stronger than the April MPR foreign exchange market and not by any specific level of and/or baseline, albeit with some loss of momentum band around the exchange rate. 3. BE: Budget estimates. in recent months over renewed infections and 4. Combined fiscal deficit refers to that of the Centre and States persisting global supply-demand imbalances in key taken together. Sources: RBI estimates; Budget documents; and IMF. inputs such as chips and semiconductors (Chapter V). Growth prospects of AEs have improved Second, the nominal exchange rate (the Indian rupee significantly on better vaccine coverage and higher or INR vis-à-vis the US dollar) has exhibited two-way fiscal support relative to emerging market and movements in a range of INR 72-75 per US dollar developing economies (EMDEs) (Chart I.2). After a since April 2021. After depreciating in early-April strong rebound in Q1:2021, the pace of expansion in on concerns about the economic fallout from the global merchandise trade has slowed, weighed down second wave, the INR remained under appreciating by elevated shipping charges and logistics costs. The pressures until May 2021. It depreciated again in June on a strengthening US dollar and rising crude global manufacturing purchasing managers’ index oil prices. The INR appreciated in August with the (PMI) remained in expansion at 54.1 in September resumption of portfolio flows, but this was reversed 2021, unchanged from August's six-month low as in September. Taking these developments into supply chain issues continued to hinder output consideration, the exchange rate is assumed at INR growth. 44Chapter I Macroeconomic Outlook Chart I.2: Global GDP Growth Chart I.3: Inflation Expectations of Households Source: IMF. Source: Inflation Expectations Survey of Households, RBI. I.2 The Outlook for Inflation outlook survey expect the cost of raw materials and selling prices to rise further in Q3:2021-22 Consumer price index (CPI) inflation breached the (Chart I.4).2 Service sector companies participating in upper tolerance threshold of 6 per cent in May and the services and infrastructure outlook survey also June 2021 driven by supply-side pressures in food, fuel and core inflation. In August 2021, inflation Chart I.4: Expectations about Cost of Raw eased to 5.3 per cent, aided by a moderation in Materials and Selling Prices momentum and favourable base effect. Looking ahead, the three months and one year ahead median inflation expectations of urban households fell by 50 basis points (bps) and 60 bps, respectively, in the September 2021 round of the Reserve Bank’s survey, tracking actual inflation dynamics.1 The proportion of respondents expecting the general price level to increase by more than the current rate decreased for three months ahead horizon but Note: Net response is the difference between the respondents reporting increased for one year ahead horizon vis-à-vis the optimism and those reporting pessimism. The range is -100 to 100. A positive/ negative value of net response is considered as optimistic/pessimistic from the previous round (Chart I.3). view point of respondent firms. Therefore, higher positive values of selling prices indicate increase in output prices while lower values for the cost of raw Manufacturing firms polled in the July-September materials indicate higher input price pressures and vice versa. 2021 round of the Reserve Bank’s industrial Source: Industrial Outlook Survey, RBI. 1 The Reserve Bank’s inflation expectations survey of households is conducted in 18 cities and the results of the September 2021 survey are based on responses from 5,958 households. 2 The results of the July-September 2021 round of the industrial outlook survey are based on responses from 1,414 companies. 55Monetary Policy Report October 2021 expect further rise in input cost pressure and selling per cent in Q3, and 5.8 per cent in Q4, with risks prices in Q3:2021-22.3 According to the respondents broadly balanced (Chart I.6). The 50 per cent and in the manufacturing and services PMIs, input and the 70 per cent confidence intervals for headline output price pressures persisted in September 2021. inflation in Q4:2021-22 are 4.4-7.2 per cent and 3.6-8.0 per cent, respectively. For 2022-23, assuming Professional forecasters surveyed by the Reserve a normalisation of supply chains on the back of Bank in September 2021 expect CPI inflation to ease improved vaccination, a normal monsoon and no from 5.3 per cent in August 2021 to 4.7 per cent in major exogenous or policy shocks, structural model Q3:2021-22 and subsequently move up to 5.7 per estimates indicate that inflation will move in a range cent in Q4:2021-22 before easing to 4.9 per cent in Q2:2022-23 (Chart I.5).4 of 4.5-5.2 per cent. The 50 per cent and the 70 per cent confidence intervals for Q4:2022-23 are 2.7-6.3 Kharif sowing has progressed satisfactorily and per cent and 1.7-7.2 per cent, respectively. foodgrains production is estimated to touch a new record which, along with ample buffer stocks of There are a number of upside and downside risks foodgrains, should help to contain cereal prices. to the baseline inflation forecasts. The upside risks Global food, oil and other commodity prices, emanate from a longer-than-expected persistence however, remain firm. Taking into account the initial of supply chain disruptions; a further hardening of conditions, signals from forward-looking surveys global commodity prices, especially that of crude oil; and estimates from structural and other time-series a quicker pass-through of input cost pressures to models, CPI inflation is projected to move from 5.6 output prices on the back of strong pent-up domestic per cent during Q1:2021-22 to 5.1 per cent in Q2, 4.5 demand from ebbing infections and vaccination-led Chart I.5: Professional Forecasters' Chart I.6: Projection of CPI Inflation (y-o-y) Projection of CPI Inflation Note: The fan chart depicts uncertainty around the baseline projection path. The baseline projections are conditioned upon the assumptions set out in Table I.2. The thick red shaded area represents 50 per cent confidence interval, implying that there is 50 per cent probability that the actual outcome will be within the range given by the thick red shaded area. Likewise, for 70 per cent and 90 per cent confidence intervals, there is 70 per cent and 90 per cent probability, respectively, that the actual outcomes will be in the range represented by the respective shaded areas. Sources: Survey of Professional Forecasters, RBI and National Statistical Office. Source: RBI staff estimates. 3 Based on 788 companies polled in July-September 2021 round of services and infrastructure outlook survey. 4 34 panellists participated in the September 2021 round of the Reserve Bank’s survey of professional forecasters. 66Chapter I Macroeconomic Outlook consumer confidence; unseasonal rainfall impacting Chart I.7: Consumer Confidence crop production; and global financial market volatility from a faster US monetary policy normalisation. The downside risks arise from an earlier than expected mending of supply chain disruptions; the persistence of weak demand and slack in the economy; and corrections in global commodity and crude prices in the event of a weakening of global demand over new mutants and poor vaccination coverage in low- income countries. I.3 The Outlook for Growth With the ebbing of the second wave, a phased relaxation of the pandemic-related localised restrictions, and improving vaccine coverage, economic activity has been normalising gradually since June 2021. Looking ahead, prospects for Source: Consumer Confidence Survey, RBI. the agricultural sector and rural demand look promising, supported by the late revival in kharif Turning to the key messages from forward-looking surveys, the consumer confidence (the current sowing. Urban demand is also likely to accelerate situation index) in the September 2021 round with the release of pent-up demand, aided by the recovered marginally from the all-time low recorded significant expansion in the pace of vaccination in May-July 2021, while index for the year ahead since July and improving consumer confidence – remained in the optimistic zone, driven by recovery as of October 6, 2021, nearly 27 per cent of India’s in sentiments on the general economic situation, adult population has been fully vaccinated, while the employment scenario and household spending 71 per cent has received one dose. This augurs well (Chart I.7).5 for the sustenance of contact-intensive activities and consumption demand. The government’s focus Sentiments in the manufacturing sector for the on capital expenditure and continued reform push, quarter ahead strengthened further in the July- large foreign direct investment flows, congenial September 2021 round of the Reserve Bank’s monetary and financial conditions, and boom in industrial outlook survey, reflecting optimism on the initial public offerings provide a conducive production, order books, capacity utilisation, and employment (Chart I.8). Services and infrastructure environment for investment activity. There are sectors expect further strengthening in overall signs that the investment pipeline could increase business situation and turnover in Q3:2021-22. in the rest of 2021-22 and in the coming year, given the interest in the production linked incentive Surveys by other agencies released during May-July (PLI) scheme and the continued focus on road generally reported a decline in business expectations infrastructure. over the previous rounds but remained upbeat from 5 The survey is conducted by the Reserve Bank in 13 major cities and the September 2021 round is based on responses from 5,237 respondents. 77Monetary Policy Report October 2021 Chart I.8: Business Assessment and Expectations Chart I.9: Professional Forecasters' Projection of Real GDP Growth Source: Industrial Outlook Survey, RBI. Sources: Survey of Professional Forecasters, RBI and National Statistical Office. a year ago (Table I.3). According to the purchasing GDP growth to move from 20.1 per cent in Q1:2021- managers’ survey for September 2021, the one 22 to 5.9 per cent in Q4; it is expected at 13.1 per year ahead business expectations of firms in the cent in Q1:2022-23 due to base effects and 6.1 per manufacturing and services sectors were optimistic cent in Q2 (Chart I.9). albeit below historical levels. While the near-term prospects are bolstered by the Professional forecasters polled in the September lower base of last year, the outlook is contingent 2021 round of the Reserve Bank’s survey expect real on the evolving COVID-19 trajectory. Taking into account the Q1 growth of 20.1 per cent, baseline Table I.3: Business Expectations Surveys assumptions, survey indicators, and model forecasts, Item NCAER FICCI Dun and CII real GDP growth is projected at 9.5 per cent in 2021- Business Overall Bradstreet Business Confidence Business Composite Confidence 22 –7.9 per cent in Q2, 6.8 per cent in Q3, and 6.1 per Index Confidence Business Index cent in Q4 – with risks evenly balanced around this (July 2021) Index Optimism (June 2021) (May 2021) Index (July baseline path (Chart I.10 and Table I.4). 2021) For 2022-23, the structural model estimates indicate Current level of 61.8 51.5 74.2 50.4 the index real GDP growth at 7.8 per cent, with quarterly growth Index as per 85.2 74.2 61.5 68.7 previous survey rates in the range of 5.0-17.2 per cent, assuming % change (q-o-q) -27.5 -30.6 20.7 -26.6 restoration of supply chains, a normal monsoon, no sequential major exogenous or policy shocks, and full vaccination. % change (y-o-y) 33.2 20.0 152.4 22.9 There are upside and downside risks to the baseline Notes: 1. NCAER: National Council of Applied Economic Research. growth path. Stronger-than-expected pent-up demand 2. FICCI: Federation of Indian Chambers of Commerce & Industry. 3. CII: Confederation of Indian Industry. amidst a faster pace of vaccination and mild variants Sources: NCAER, FICCI, CII and Dun & Bradstreet Information Services of the virus, and government’s focus on infrastructure India Pvt. Ltd. 88Chapter I Macroeconomic Outlook Table I.4: Projections - Reserve Bank and Chart I.10: Projection of Growth in Real GDP (y-o-y) Professional Forecasters (Per cent) 2021-22 2022-23 Reserve Bank’s Baseline Projections Inflation, Q4 (y-o-y) 5.8 4.5 Real GDP growth 9.5 7.8 Median Projections of Professional Forecasters Inflation, Q4 (y-o-y) 5.7 4.9* Real GDP growth 9.4 6.8 Gross domestic saving (per cent of GNDI) 29.5 29.8 Gross capital formation (per cent of GDP) 30.0 30.7 Credit growth of scheduled commercial banks 7.5 8.1 Note: The fan chart depicts uncertainty around the baseline projection Combined gross fiscal deficit (per cent of GDP) 10.5 9.0 path. The baseline projections are conditioned upon the assumptions set out Central government gross fiscal deficit (per cent of 6.8 5.6 in Table I.2. The thick green shaded area represents 50 per cent confidence GDP) interval, implying that there is 50 per cent probability that the actual outcome will be within the range given by the thick green shaded area. Likewise, for Repo rate (end-period) 4.0 4.25* 70 per cent and 90 per cent confidence intervals, there is 70 per cent and 90 per cent probability, respectively, that the actual outcomes will be in the range Yield on 91-days treasury bills (end-period) 3.8 4.3 represented by the respective shaded areas. Yield on 10-year central government securities 6.4 6.6 Source: RBI staff estimates. (end-period) Overall balance of payments (US$ billion) 50.6 35.0 variants, have a significant bearing on the inflation Merchandise exports growth 30.0 8.0 and growth trajectories. Some plausible alternative Merchandise imports growth 36.1 9.1 scenarios to assess the balance of risks around the Current account balance (per cent of GDP) -0.7 -1.1 baseline projections are presented in this section. *: Q2:2022-23. Note: GNDI: Gross National Disposable Income. (i) Global Growth Uncertainties Sources: RBI staff estimates; and Survey of Professional Forecasters (September 2021). While the global growth outlook has been upgraded relative to the April MPR, it remains highly susceptible investment and asset monetisation and reform to COVID-19’s trajectory in view of the uneven spread measures provide an upside to the baseline growth of vaccination across countries and more contagious path. On the contrary, new and more contagious new variants of the virus, apart from volatility in global variants of the virus, elevated levels of crude oil and commodity prices and the elevated uncertainty over commodity prices, more persistent pandemic-related US monetary policy normalisation. First, continuing domestic as well as global supply bottlenecks and global supply chain disruptions are adversely global financial market volatility pose downside risks impacting production in several manufacturing to the baseline growth path. activities and could dampen global growth more than I.4 Balance of Risks currently anticipated with additional headwinds The baseline projections of inflation and growth from the steep increase in natural gas prices in recent presented in the previous sections are premised weeks. Second, a slowing Chinese economy may drag on the assumptions relating to key domestic and down external demand. Third, if the inflationary international macroeconomic and financial conditions pressures emanating from the demand-supply set out in Table I.2. The inherent uncertainties around bottlenecks in the US and other AEs were to turn out these assumptions, exacerbated by COVID-19 and its to be persistent, it could trigger an earlier exit than 99Monetary Policy Report October 2021 currently being telegraphed from the accommodative plus. The supply-demand dynamics in the global oil policies in the major AEs, induce large financial market are subject to several uncertainties. On the market volatility and pose downside risks to global supply side, shortfall in the OPEC plus production growth. Fourth, an escalation of geo-political tensions and rise in geo-political tensions could constrain remains a potential source of downside risk to global supply and increase oil prices above the baseline. On growth. In such a scenario, if the global recovery slips the demand side, a better containment of COVID-19 by 100 bps below the baseline, domestic growth and infections could induce higher global growth, a inflation could be lower by around 40 bps and 30 faster closing of the global output gap and a sharper bps, respectively. Conversely, a more widespread and increase in international crude oil prices. Assuming equitable distribution of vaccines across the world, crude oil prices to be 10 per cent above the baseline sustained success in containing the spread of new (Table I.2), domestic inflation could be higher by 30 mutants, faster resolution of logistic bottlenecks, bps and growth weaker by around 20 bps over the and the spike in inflation in major AEs reversing baseline. Conversely, crude oil prices could soften quickly could boost global economic activity. In such below the baseline if the global recovery is more a scenario, assuming that global growth surprises by subdued owing to a faster spread of virus mutations, 100 bps on the upside, domestic growth and inflation delays in vaccination or improved supplies of shale could edge higher by around 40 bps and 30 bps, gas. In this scenario, if the price of the crude falls by respectively (Charts I.11a and I.12a). 10 per cent relative to the baseline, inflation could ease by around 30 bps with a boost of 20 bps to (ii) International Crude Oil Prices growth (Charts I.11a and I.12a). International crude oil prices have firmed up amidst (iii) Exchange Rate elevated volatility with the gradual resumption in economic activity, improvement in global demand The INR has exhibited two-way movements over the and calibrated output normalisation by the OPEC past six months, reflecting both global and domestic Chart I.11: Impact of Risk Scenarios on the Baseline Inflation Path a. Crude Oil Prices and Global Demand Shocks b. Exchange Rate and Food Price Shocks Source: RBI staff estimates. 1100Chapter I Macroeconomic Outlook factors. The divergent paths of recovery across AEs resultant heightened volatility in global financial and EMEs and the risk of currently elevated inflation markets could lead to a generalised risk aversion in AEs acquiring a more structural character could to EMEs assets, capital outflows and downward necessitate an early exit from ultra-accommodative pressures on their currencies (Box I.1). A 5 per cent monetary policies by the AE central banks. The depreciation of INR from the baseline (Table I.2) in Box I.1: Capital Flow and Exchange Rate Shocks: Macroeconomic Implications Capital flows to EMEs ease external financing constraints The macroeconomic implications of capital flows for the and help to increase domestic investment and growth. On Indian economy can be analysed through the Quarterly the other hand, such flows are often volatile and prone to Projection Model (QPM)6 (RBI, 2021) under alternative sudden stops and reversals, causing disorderly movements scenarios. In Scenario 1, the central bank allows the in the exchange rate that can feed into domestic inflation impact of capital flows to be borne out fully by the and output. These effects are amplified by interactions exchange rate with no monetary action. In Scenario with equity and bond markets and derivative positions. 2, movements in the exchange rate pass through into Furthermore, undesirable and unintended fluctuations in inflation, causing a deviation of inflation from the target liquidity resulting from volatile capital flows can vitiate that prompts monetary policy action. Alternatively, the monetary policy stance (Das, 2021). the central bank may resort to a judicious combination Chart I.1.1: Capital Flows and Exchange Rate: Impact on Inflation and Growth Change in Reserves* Policy Rate Nominal Exchange Rate Output Gap Price Level Headline Inflation *: Per cent of nominal GDP. Note: x-axes indicate quarters after the shock and y-axes indicate deviations from the baseline path in percentage points. Charts show the impact of an exogenous capital outflows shock (calibrated to one per cent of nominal GDP) on the economy. Scenarios 1, 2 and 3 are described in the text. Source: RBI staff estimates. (Contd.) 6 The QPM is a semi-structural, forward-looking, open economy, calibrated, gap model in the New Keynesian tradition and provides an internally consistent analysis of various feedback mechanisms (RBI, 2021). 1111Monetary Policy Report October 2021 of forex intervention and sterilisation, exchange rate a relatively more accommodative monetary policy in adjustment and monetary policy action (Scenario 3) to support of growth. The Reserve Bank of India undertakes contain the impact of the volatility in capital flows on the two sided interventions in the spot, forward and futures domestic economy. markets to stabilise financial markets and liquidity In Scenario 1, there is a sustained deviation of inflation conditions so that monetary policy retains its domestic from the target (Chart I.1.1). Inflation deviations are orientation and the independence to pursue national relatively contained in scenario 2 but this comes at the objectives. cost of volatility in output because monetary policy is References: calibrated to bring inflation back to the target. Scenario 3, which involves forex intervention and sterilisation, Das, Shaktikanta (2021), “Governor’s Statement”, June 4, helps to insulate the domestic economy from the capital 2021, Reserve Bank of India. flows shock, with only marginal impact on inflation and Reserve Bank of India (2021), Monetary Policy Report, output. This policy combination reduces volatility in the forex market and helps the central bank to pursue April 2021. such a scenario could increase domestic inflation by by around 20 bps and 15 bps, respectively (Charts up to 20 bps, while GDP growth could be higher by 15 I.11b and I.12b). bps through a boost to exports. On the other hand, (iv) Food Inflation given India’s relatively better growth outlook, boost to growth from the expanding scale of vaccination Food inflation moderated in July-August from the recent and reform measures by the government to attract peak in June 2021, driven largely by the deepening foreign capital, INR could appreciate. In such a deflation of vegetable prices. Inflation in edible oil scenario, if the INR appreciates by 5 per cent relative prices, however, remains substantially elevated at to the baseline, inflation and growth could moderate 33.0 per cent in August. The expectations of record Chart I.12: Impact of Risk Scenarios on the Baseline Growth Path a. Crude Oil Prices and Global Demand Shocks b. Exchange Rate and Food Price Shocks Source: RBI staff estimates. 1122Chapter I Macroeconomic Outlook kharif foodgrains production and large buffer stocks pace of vaccination, release of pent-up demand in the for cereals augur well for food prices. These upcoming festival season, boost to investment activity developments along with continued effective from the government’s focus on infrastructure and supply management of key food items and easing asset monetisation, and accommodative monetary of international food prices could soften headline and liquidity conditions provide an upside to the inflation by around 50 bps. Conversely, a further baseline growth path. While the inflation trajectory hardening of international food prices, demand- is expected to be driven by supply-side factors and supply imbalances in some food items and unseasonal risks are to the upside, a faster resolution of global rainfall could exert upward pressure on headline as well as domestic supply chain disruptions, inflation by around 50 bps (Charts I.11b and I.12b). softer international crude oil and food prices as I.5 Conclusion pent-up demand normalises, and another round of Domestic economic activity is normalising after the good foodgrains production and effective supply ferocious second wave retarded momentum. The management, could cause inflation to undershoot outlook remains overcast by the future path of the the baseline, contingent on the evolution of the pandemic; however, the accelerated progress in the pandemic and the efficacy of vaccines. 1133Monetary Policy Report October 2021 II. Prices and Costs Consumer price index (CPI) inflation remained highly volatile during March-August this year – after moderating close to the target rate in April, it rose abruptly to breach the upper tolerance threshold during May-June with a sharp pickup in food, fuel and core inflation and moderated in July-August on substantial softening in food inflation. Costs of farm and non-farm inputs remained elevated. Nominal rural wages for both agricultural and non- agricultural labourers were stagnant while staff costs in the organised sector rose. Since the publication of the April 2021 MPR, headline moderated by one percentage point to 5.3 per cent CPI inflation1 that had fallen close to the target rate by August on a substantial softening in food inflation of 4.0 per cent in April, sprang back amidst the even as fuel infation scaled another high and core second wave of intense infections to breach the upper inflation remained sticky and elevated. On the whole, tolerance threshold and touched 6.3 per cent during CPI inflation has been highly volatile in the five May-June 2021.2 This unanticipated spike came from months of the current financial year – moving within a wide range of 4.2 per cent to 6.3 per cent – averaging a sharp pick-up in food and core (CPI excluding food 5.5 per cent (Chart II.1). and fuel3) inflation which peaked peaked at 6.6 per cent in May 2021 – the highest since May 2014, and The Reserve Bank of India (RBI) Act enjoins the RBI fuel inflation which at 12.6 per cent in June 2021 to set out deviations of actual inflation outcomes was the then highest recorded in the CPI series. In from projections, if any, and explain the underlying the following months, however, inflation quickly reasons thereof. The April 2021 MPR had projected Chart II.1: CPI Inflation (y-o-y) Note: The imputed CPI prints for April and May 2020 have been regarded as a break in the CPI series. Sources: National Statistical Office (NSO); and RBI staff estimates. 1 Headline inflation is measured by year-on-year changes in all-India consumer price index – combined (CPI-C). 2 CPI inflation for April-May 2021 was computed based on imputed CPI indices for April-May 2020. 3 Core CPI, i.e. CPI excluding food and fuel is worked out by eliminating the groups ‘food and beverages’ and ‘fuel and light’ from the headline CPI. 1144Chapter II Prices and Costs range-bound movement in CPI inflation – an average normalised, the effects of these factors dissipated of 5.0 per cent in Q4:2020-21 to 5.2 per cent in Q1 and from June. Second, the unanticipated surge in global Q2 of 2021-22. Actual inflation for Q1:2021-22 at 5.6 energy prices kept petrol and diesel inflation firmly per cent and Q2:2021-22 (July-August) at 5.4 per cent in double digits. The April 2021 MPR had assumed an turned out to be higher than the projections by 35 bps Indian basket crude oil price of US$ 64.6 per barrel and 27 bps, respectively (Chart II.2). during 2021-22; however, crude oil prices edged up to a peak level of US$ 75 per barrel in early July before A number of factors impinging on food, fuel and core moderating to US$ 70 per barrel by end-August. Third, contributed to this overshoot. First, the rapid spread there was an extraordinary surge in international of COVID-19’s second wave at the start of 2021-22 edible oil prices which fed into domestic inflation resulted in restrictions on activity being imposed over formation.5 Fourth, the persistence of industrial a large swath of the country. These restrictions, in turn, input and transport cost pressures and subsequent resulted in transitory price pressures in Q1, especially transmission to selling prices of manufactured in May, through supply-chain disruptions, elevated goods was more than what was anticipated, in spite retail margins as well as from difficulties in accurate of demand conditions weakening due to the second price measurements due to localised lockdowns and wave. restrictions on non-essential commercial activities II.1 Consumer Prices in several states.4 As restrictions eased and activity A dip in inflation to 4.2 per cent in April 2021 was overwhelmed in May 2021 by a sharp pick up in Chart II.2: CPI Inflation (y-o-y): price momentum6 spanning across food, fuel and Projection versus Actual core groups, resulting in a surge in inflation by 2.1 percentage points to 6.3 per cent. In June, headline inflation plateaued, with positive price momentum completely neutralised by a favourable base effect which became even larger in July and more than offset the broad-based price momentum taking down headline inflation to 5.6 per cent in July. With overall price momentum registering a sharp deceleration in August, coming from a steady food price index, headline inflation moderated further to 5.3 per cent (Chart II.3). The distribution of CPI inflation during January- *: Projection for entire Q2:2021-22 vis-a-vis actual average inflation during July- August 2021. August 2021 varied distinctly from the pattern in Sources: NSO; and RBI staff estimates. the past few years. There has been a shift in the 4 In May 2021, the market-wise price reporting fell to 68.1 per cent in rural areas (from 84.6 per cent in April 2021 and 89.1 per cent in March 2021) and 67.5 per cent in urban areas (from 87.4 per cent in April 2021 and 93.6 per cent in March 2021). 5 About 58 per cent of the domestic consumption of edible oil is imported. 6 A change in CPI year-on-year (y-o-y) inflation between any two months is the difference between the current month-on-month (m-o-m) change in the price index (momentum) and the m-o-m change in the price index 12 months earlier (base effect). For more details, see Box I.1 of the MPR, September 2014. 1155Monetary Policy Report October 2021 Chart II.3: CPI Inflation – Momentum and Base Effects a: CPI Headline b: CPI Food and Beverages c: CPI Fuel and Light d: CPI excluding Food and Fuel Note: The y-o-y inflation for April and May 2021 have been calculated based on the imputed index for April and May 2020 released by NSO. Sources: NSO; and RBI staff estimates. mean of the distribution from 3.4 per cent for 2017- Chart II.4: Average CPI Inflation (y-o-y) 2019 (January-August) to 5.3 per cent in 2021 so far (Kernel Density Estimates) (Chart II.4). This was accompanied by an increase in volatility – with the standard deviation in 2021 more than two times that of 2017-2019 – and positive skewness, compared to a negative skew for the 2017-2019 period. These indicate high dispersion of inflation rates in the CPI basket, along with a larger number of items experiencing higher inflation rates than in the pre-pandemic period. The positive skew reflected outlier double-digit inflation in the CPI distribution, primarily on account of oils and fats. During April-August 2021, 8 of the 23 sub-groups in CPI with a cumulative weight of 49.7 per cent Sources: NSO; and RBI staff estimates. 1166Chapter II Prices and Costs Table II.1: Contribution of CPI sub-groups to Headline CPI Inflation Sr. Commodity Weight FY 2020-21 (June-March)* FY 2021-22 (April-August) No. Average inflation Average contribution Average inflation Average contribution (y-o-y, per cent) (per cent) (y-o-y, per cent) (per cent) 1 Oils and fats 3.56 16.8 9.1 31.4 18.3 2 Transport and communication 8.59 10.6 13.4 11.1 15.6 3 Fuel and light 6.84 2.8 3.3 11.6 13.4 4 Health 5.89 5.4 5.7 7.9 8.6 5 Meat and fish 3.61 16.0 10.8 9.6 8.0 6 Housing 10.07 3.2 5.8 3.8 7.2 7 Prepared meals, snacks, sweets etc. 5.55 4.5 4.7 5.6 6.0 8 Clothing 5.58 3.4 3.4 5.7 5.7 Total 49.69 6.8 56.2 9.4 82.7 CPI-Combined 100.00 6.1 100.0 5.5 100.0 * The imputed CPI prints for April and May 2020 have been regarded as a break in the CPI series. Sources: NSO; and RBI staff estimates. contributed 82.7 per cent of CPI inflation, much higher Chart II.5 Diffusion Indices: CPI than their contribution of 56.2 per cent in 2020-21 (M-o-M Non-Seasonally Adjusted) (Table II.1). The non-seasonally adjusted diffusion indices of price changes7 remained elevated (barring for services in June), indicative of price increases being broad-based across the CPI basket (Chart II.5).8 II.2 Drivers of Inflation The role of various factors impinging upon inflation dynamics can be captured through vector autoregression (VAR) estimates and historical decomposition.9 Inflationary pressures in Q1:2021-22 can be attributed to adverse supply shocks, firming up of asset prices and easy monetary conditions, Sources: NSO; and RBI staff estimates. even as muted demand conditions contributed to a softening of inflationary pressures. By Q2:2021-22 In terms of contribution of goods and services to some softening in inflationary pressures came about headline inflation, the pick-up in inflation in June from softening of wage pressures (Chart II.6a). 7 In view of the non-availability of CPI item level data for the period March-May 2020, the diffusion indices have been constructed with item level indices without seasonal adjustment. 8 The CPI diffusion index, a measure of dispersion of price changes, categorises items in the CPI basket according to whether their prices have risen, remained stagnant or fallen over the previous month. A reading above 50 for the diffusion index signals a broad expansion or generalisation of price increases and a reading below 50 signals broad-based price decline. 9 Historical decomposition estimates the contribution of each shock to the movements in inflation over the sample period (Q4:2010-11 to Q1:2021-22) based on a vector autoregression (VAR) with the following variables (represented as the vector Y) – crude oil prices; exchange rate (INR per US$), asset t price (BSE Sensex), CPI; the output gap; rural wages; the policy repo rate; and money supply (M). All variables other than policy repo rate are growth rates. 3 The VAR can be written in reduced form as: Y =c + A Y + e; where e represents a vector of shocks. Using Wold decomposition, Y can be represented t t-1 t t t as a function of its deterministic trend and sum of all the shocks e. This formulation facilitates decomposition of the deviation of inflation from its t deterministic trend into the sum of contributions from various shocks. 1177Monetary Policy Report October 2021 2021 emanated from perishables – edible oils, fruits semi-perishables, durables and services to headline and vegetables – and semi-perishable goods (non- inflation were largely steady (Chart II.6b). Some durable goods with a 30-day recall10) like LPG, kerosene, of the stickiness in semi-perishables and durables petrol, diesel, medicines and fast-moving consumer goods inflation reflected the transmission of high international prices. goods (FMCGs). In July-August, the contribution of perishables to headline inflation registered a The surge in international prices of edible oil, silver sharp moderation, even as the contributions of and petroleum products resulted in an increase in Chart II.6: Drivers of CPI Inflation a: Decomposition of CPI Inflation* * Deviation from deterministic trend. Note: Estimated using a vector autoregression (see footnote 9 for details). Sources: NSO; RBI; Petroleum Planning & Analysis Cell (PPAC); BSE; Labour Bureau; and RBI staff estimates. b: Contribution of Goods and Services c: Contribution of Imported Inflation Note: Figures in parentheses indicate weights in CPI. Sources: NSO; and RBI staff estimates. 10 The CPI weighting diagrams use the modified mixed reference period (MMRP) data based on the 2011-12 Consumer Expenditure Survey conducted by the National Sample Survey Office (NSSO). Under MMRP, data are collected on expenditure incurred for frequently purchased items – edible oil, eggs, fish, meat, vegetables, fruits, spices, beverages, processed foods, pan, tobacco and intoxicants – during the last seven days; for clothing, bedding, footwear, education, medical (institutional), durable goods, during the last 365 days; and for all other food, fuel and light, miscellaneous goods and services including non-institutional medical services, rents and taxes, data relate to the last 30 days. 1188Chapter II Prices and Costs the contribution of imported components to headline alcoholic beverages and spices were higher than their inflation – from 0.8 percentage points in February to long-term averages (Chart II.8). Excluding vegetables, a peak level of 1.9 percentage points in June before during April-August 2021, food and headline inflation moderating to 1.4 percentage points in August 2021 would have averaged 6.3 per cent and 6.5 per cent (Chart II.6c). respectively, as against an overall average rate of 4.3 per cent for food and 5.5 per cent for headline. Food Group Prices of cereals (weight of 9.7 per cent in the CPI Food and beverages inflation treaded within a range and 21.1 per cent in the food and beverages group) of 2-6 per cent during March-August 2021 and on an remained in deflation during March-August 2021, average contributed around 37.2 per cent of headline primarily reflecting favourable base effects and inflation (CPI food has a weight of 45.9 per cent in the CPI basket). Elevated international prices of edible muted momentum. Within cereals, both rice and oils along with price pressures in protein rich items wheat witnessed subdued price pressures (barring remained the major drivers (Chart II.7). The summer May 2021) on the back of ample buffer stocks relative uptick in vegetables prices during May-July 2021 led to norms (2.7 times and 1.8 times for rice and to an increase in price pressures, while a decline wheat, respectively, as on September 16, 2021) and in prices of cereals, protein-based food and fruits distribution under Pradhan Mantri Garib Kalyan Anna along with a sharp deceleration in vegetable price Yojana (PMGKAY). In May 2021, restrictions on activity momentum in August 2021 provided relief dragging across many states affected supply chains leading to down food inflation to 3.8 per cent. Overall, the a pick up in prices. Moreover, production remained food price build-up in the financial year so far has robust, with an increase of 2.9 per cent for rice and 1.5 been lower than historical patterns, even as price per cent for wheat (as per the 4th Advance Estimates build-ups in oils and fats, eggs, meat and fish, non- (AE) 2020-21) over 2019-20 Final Estimates (FE). Chart II.7: CPI Food Inflation a: Drivers of CPI Food Inflation b: Drivers of CPI Protein-based Food Inflation *: Includes meat & fish, egg, milk and pulses. **: Includes fruits, sugar, non-alocoholic beverages and prepared meals. Note: Figures in parentheses indicate weights in CPI-Protein based food. Note: Figures in parentheses indicate weights in CPI food and beverages. Sources: NSO; and RBI staff estimates. 1199Monetary Policy Report October 2021 Chart II.8: Financial Year Price Build-up (August over March) Note: Figures in parentheses indicate weights in CPI- food and beverages. Sources: NSO; and RBI staff estimates. In the case of vegetables (weight of 6.0 per cent in the uptick. While prices of potatoes and onions eased in CPI and 13.2 per cent in the food and beverages group), August 2021, tomato prices picked up due to lower prices remained in deflation during March-August supply in the markets as the lean period set in. Crop 2021 (Chart II.9), reflecting, inter alia, favourable base damage due to heavy rains and flood like situations in effects. The three key vegetables – tomatoes, onions major tomato producing states such as Andhra Pradesh and potatoes – largely witnessed price increases and Karnataka also impacted mandi arrivals. After during May-July 2021 less than the usual summer moderating during March-May 2021, onion prices Chart II.9: Drivers of Vegetables Inflation (y-o-y) Note: Figures in parentheses indicate items' weights in CPI-Vegetables. Item level data were not released by NSO for the months of March, April and May 2020. Sources: NSO; and RBI staff estimates. 2200Chapter II Prices and Costs edged up subsequently, reflecting the seasonal uptick historical average in the financial year so far, reflecting as well as damage to stored rabi onions in Maharashtra the recovery of production (higher by 4.2 per cent in and Gujarat due to cyclone Tauktae. Potato prices 2020-21 2nd AE compared to 2019-20 FE). were in deflation during June-August 2021, reflecting In a rapidly changing scenario where volatility in favourable base effects and easing of prices in August prices of key vegetables has substantial fallout 2021 with higher production (10.6 per cent in 2020- on headline inflation, there is a need for real 21) in response to elevated prices observed in the time monitoring of price situation, especially in previous year, and higher cold storage stocks in major case of perishables. Price sentiment derived from producing states. On the whole, as noted earlier, the unstructured data contained in news articles can price build-up in vegetables remained lower than their provide useful leading information on prices (Box II.1). Box II.1: News Sentiment-based Analysis of Food Inflation Outlook Strengthening market intelligence on high-impact food weight of 2.2 per cent in the CPI, have high contribution items is an integral element in inflation forecasting to variance in food price inflation (Chart II.1.1). framework of the Reserve Bank. Newspaper articles A lexicon-based approach was adopted for computation provide information on local events that may lead to large of commodity-wise sentiment index, based on news swings in nation-wide retail food prices. Unstructured items published in nine leading news dailies during textual data in news items can be processed and quantified the period 2016-202011. For each commodity-specific using text-mining techniques to analyse the nature of news item, the Loughran-McDonald lexicon, designed shocks and inflation dynamics. Three main vegetables viz., specifically for analysing economic and financial texts tomatoes, onions and potatoes (TOP), with a combined was used to assign a sentiment score to each polarized word occurring in a news article published at time (Loughran and McDonald, 2011). ‘Positive’ Chart II.1.1: Contribution of TOP to Variance in (indicating easing in prices) and ‘negative’ (indicating Food Inflation increase in prices) words were assigned a sentiment score of (+1) and (-1), respectively. A sentiment score ( ) was computed at the document level such that where represents the total number of polarized words and is the total number of words in a news article. The document-wise sentiment score was aggregated across time such that represents the time-series for the final net sentiment score (NSS), where is total number of news articles for the given commodity on day ‘t’. Accordingly, a positive sentiment score indicates an expected fall in prices, while a negative sentiment score suggests an expected Note: * Covers April 2019 to February 2020, as item level data for March-May increase in prices. 2020 were not released by NSO. (Contd.) 11 Measured using words occurring in each news article, sentiments in this context can be construed to convey optimism (decrease) or pessimism (increase) about the price situation of a given commodity. For the analysis, a novel dataset of daily news items published in nine leading news dailies during 2016-2020 was constructed and filtered based on occurrence of keywords encompassing ‘supply’, ‘demand’ and ‘prices’ of TOP commodities. The framework laid down by Ardia et al. (2021) was used for sentiment computation and analysis. 21Monetary Policy Report October 2021 Chart II.1.2: Major Price Shock Events and Net Sentiments (a) Tomato (b) Onion (c) Potato Note: The shaded areas in graphs represent the following episodes: Tomato: (I) Heatwave affected production (II) Farmers’ protests (III) Excess rains; Onion: (I) Excess rains (II) Late withdrawal of monsoon (III) Excess rains; Potato: (I) Low production – blight in West Bengal (II) Low production (III) Low storage. Sources: NSO; and RBI staff estimates. Monthly net sentiment score of TOP and changes causality test), which could be useful for nowcasting of in their prices as reflected in CPI show a negative food price inflation. relationship between them, as expected (Chart II.1.2). References: Large increases in TOP prices seen after major supply shocks coincide with large fall in sentiment related Ardia, D., Bluteau, K., Borms, S., and Boudt, K. (2021). to each of the three commodities. Sentiments were The R Package Sentometrics to Compute, Aggregate and found to ‘Granger cause’ change in prices, implying the Predict with Textual Sentiment. Journal of Statistical predictive power of news-based sentiment in capturing Software, 99(2). future price movements of TOP. The results show that Loughran, T., and McDonald, B. (2011). When is a Liability NSS can provide forward-looking information for price not a Liability? Textual Analysis, Dictionaries, and 10- movements in TOP (up to 30 days as per the Granger Ks. The Journal of Finance, 66(1), 35-65. 2222Chapter II Prices and Costs Despite pulses production of 257.2 lakh tonnes chicken, mutton and fish surged as a consequence during 2020-21, an increase of 11.7 per cent over of several factors – increase in soybean meal prices 2019-20 – augmenting domestic supply and overall (international soybean meal prices increased by 32.3 stocks, factors like localised lockdowns in the second per cent in July 2021 compared to July 2020); restricted wave resulted in supply chain driven demand- operations of the poultry industry during the second supply gaps, accentuated by lower arrival of imports wave; festive demand in July 2021; damage of fishing and precarious stock positions in the case of masur boats owing to cyclones Tauktae and Yaas; higher fuel (Chart II.10). To address the tight demand supply prices and the annual ban on fishing in the west coast situation, the government undertook several supply during monsoons. However, prices eased in August side initiatives such as imposing stock limits in 2021 reflecting seasonal fall in demand during the July 2021 on some pulses under the Essential month of sravana. Commodities Act, 1955, easing import restrictions In the case of milk and products (weight of 6.6 per cent to enhance domestic availability of tur, urad and in the CPI and 14.4 per cent in the food and beverages moong, a memorandum of understanding (MoUs) group), a lean season of production coincided with with Myanmar, Malawi and Mozambique for upward revision in retail prices by ` 2 per litre by pulses imports, and reducing basic import duty and major milk co-operatives like Amul and Mother Dairy Agriculture Infrastructure and Development Cess in July 2021 which was followed by many other state (AIDC) on masur to 0 per cent12 and 10 per cent, milk co-operatives such as Milkfed in Punjab, Gokul respectively. in Maharashtra and Parag in Uttar Pradesh, resulting Inflation in meat, fish and eggs witnessed upside in price pressures in July 2021. Milk cooperatives pressures during March-July 2021 primarily reflecting have cited various reasons for increase in input costs feed cost pressures and transportation costs such as cost of transport, feed prices and operational (Chart II.11a). Prices of key items such as eggs, costs of processing and packaging. However, post July Chart II.10: Pulses Inflation and Stock-Use Ratio: Monthly Balance Sheet Sources: MOSPI, DGCIS, CACP, Ministry of Agriculture and RBI staff estimates. 12 For non-US origin. 2233Monetary Policy Report October 2021 2021, no increase in retail milk prices by other milk applicable till December 31, 2021. Further, effective cooperatives has been reported. September 11, 2021, import duty on crude and refined palm oil was reduced from 10 per cent to 2.5 per cent Inflation in oils and fats experienced price pressures (effective rate reduced from 30.25 per cent to 24.75 in the post-lockdown period and shot up to an all-time per cent) and 37.5 per cent to 32.5 per cent (effective high of 34.8 per cent in June 2021, mirroring elevated rate reduced from 41.25 per cent to 35.75 per cent), international edible oil prices (Chart II.11b). Prices fell respectively. However, price pressures continued in in July 2021 in response to the supply side measures the domestic market (barring in July 2021) as Malaysia announced by the government, before showing some increased its export reference price for July 2021, uptick in August to 33.0 per cent. Global palm oil maintaining its export duty at the highest rate of 8.0 prices escalated due to labour shortage in Malaysia per cent. To control domestic edible oil prices, import and adverse weather conditions leading to lower than expected production and high export duties on crude duty on crude soybean and sunflower oil were reduced palm oil. A number of measures were taken to alleviate from 15.0 per cent to 7.5 per cent, effective August 20, price pressures, including reduction in import duty on 2021 and it was further reduced to 2.5 per cent from crude and refined palm oil from 15.0 per cent to 10.0 September 11, 2021. Similarly, import duty on refined per cent (effective rate reduced from 35.75 per cent soybean and sunflower oils was reduced from 45.0 per to 30.25 per cent) and 45.0 per cent to 37.5 per cent cent to 37.5 per cent and further to 32.5 per cent with (effective rate reduced from 49.5 per cent to 41.25 per the same effective dates. To attain self-sufficiency in cent), respectively; mechanism for speedy clearance production of edible oil, the Government announced of crude palm oil at shipping ports and placing the a National Mission on Edible Oil - Oil Palm (NMEO- imports of Refined Bleached Deodorized (RBD) palm OP) with an investment of over `11,000 crore and oil and RBD palmolein under free category from assured farmers access to all facilities, from quality restricted category effective from June 30, 2021 and seeds to technology. Chart II.11: Drivers of Price Pressures in Animal Protein and Oils and Fats a: Drivers of Animal Protein Price s b: Movement in Edible Oil Inflation: (H1:2021-22 over H2:2020-21) Global vs Domestic Note: Data for H1:2021-22 pertain to April-August 2021. Figures in parentheses indicate weight in CPI-animal protein group. Sources: NSO and World Bank Pink Sheet. 2244Chapter II Prices and Costs Price of sugar and confectionery (weight of 1.4 per Retail Margins cent in the CPI and 3.0 per cent in the food and Retail price margins, defined as the difference beverages group) remained in deflation during March- between retail and wholesale prices for four major August 2021, except for June 2021, due to higher sub-groups – cereals, pulses, vegetables and edible oil domestic availability as a result of robust production – have shown divergent movements.13 The margins (sugarcane production rose by 7.8 per cent in 2020-21 in case of edible oils, pulses and cereals have risen 4th AE over 2019-20 FE) and export subsidy for sugar unceasingly, since the first wave of the COVID-19 export under MAEQ (Maximum Admissible Export pandemic. Margins in case of vegetables are back to Quota) being reduced to `4000 per tonne from `6000 the usual seasonal pattern in absence of any major per tonne, effective May 20, 2021. supply side disturbance (Chart II.12). CPI Fuel Group Among other items in the CPI food group, prices firmed up in the case of non-alcoholic beverages and CPI fuel inflation surged from 4.4 per cent in March prepared meals, reflecting increase in input costs. 2021 to 12.6 per cent in June 2021 before showing a Chart II.12: Retail Margins a: Cereals b: Pulses c: Vegetables d: Edible Oil Sources: Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution; and RBI staff estimates. 13 Item level retail and wholesale prices sourced from the Department of Consumer Affairs (DCA) are aggregated at respective subgroup using item level CPI weights. Data for January-March 2021 have been excluded due to changes in price collection mechanism and item varieties by DCA. 2255Monetary Policy Report October 2021 transitory dip in July. In August 2021, fuel inflation contribution of fuel items of rural consumption like touched an all-time high of 12.9 per cent (Chart firewood and chips was also substantial during June- II.13a). The year-on-year price changes in LPG and August 2021 (Chart II.13b and II.13c). kerosene (PDS) during June-August 2021 were one of CPI excluding Food and Fuel the highest recorded in the current CPI series. Market prices of crude and various oil-based fuels have CPI core inflation, i.e. CPI inflation excluding food and firmed up through the waves of the pandemic pulling fuel, remained elevated and sticky in the financial up kerosene and LPG fuel prices (Chart II.13c). The year so far, reflecting persistent cost-push pressures Chart II.13: CPI Fuel Group Inflation a: Drivers *: Includes diesel [excl. conveyance], coke, coal, charcoal and other fuels. Note: Figures in parentheses indicate weights in CPI - fuel and light. b: Kerosene: Domestic and International Prices c: LPG: Domestic and International Prices Notes: (1) The international price for LPG is based on spot prices for Saudi Butane and Propane, combined in the ratio of 60:40 respectively. These international product prices are indicative import prices. Further details are available at www.ppac.org.in. (2) The indicative international price for kerosene is the Singapore Jet Kero spot price. (3) The domestic prices of LPG and kerosene represent the average prices at four metros from Indian Oil Corporation Limited (IOCL). Sources: NSO; Bloomberg; IOCL; and RBI staff estimates. 2266Chapter II Prices and Costs Table II.2: Exclusion-based Measures of Inflation (y-o-y) Chart II.14: Contribution to CPI excluding Food Period CPI excluding CPI excluding CPI excluding Fuel (Core) Inflation (in percentage points) food and fuel food, fuel, food, fuel, petrol, (47.3) petrol and diesel, gold and diesel (45.0) silver (43.8) Jun-19 4.1 4.6 4.6 Sep-19 4.2 4.9 4.5 Dec-19 3.8 3.7 3.3 Mar-20 3.9 Jun-20 5.4 5.3 4.6 Sep-20 5.4 5.2 4.5 Dec-20 5.6 5.3 4.7 Jan-21 5.5 5.2 4.7 Feb-21 6.0 5.5 5.1 Mar-21 5.9 Apr-21 5.3 May-21 6.6 Jun-21 6.1 5.3 5.4 Jul-21 5.8 5.1 5.3 Aug-21 5.8 5.1 5.5 Note: (1) Figures in parentheses indicate weights in CPI. (2) Derived as residual from headline CPI. Sources: NSO; and RBI staff estimates. * Others include pan, tobacco and intoxicants; and recreation and amusement. Note: Figures in parentheses indicate weights in CPI excluding food and fuel. even as demand conditions remained sluggish. Core Sources: NSO; and RBI staff estimates. inflation, from a peak level of 6.6 per cent in May, moderated to 6.1 per cent in June and to 5.8 per cent 2021 – has kept petrol and diesel inflation firm at 23.8 during July-August. Excluding petrol and diesel, it has per cent in August. This was starkly evident in the also remained sticky in the range of 5.1-5.5 per cent WPI which excluded indirect tax effects; WPI petrol throughout the pandemic period (Table II.2). and diesel inflation was at 54.2 per cent in August In term of sub-groups, transport and communication, (Chart II.15a). Petrol pump prices were at historic clothing and footwear and health accounted for more highs in early 2021 and breached `100 per litre by than 60 per cent of core inflation (weight of these July 2021, with attendant implications for overall cost sub-groups is around 45 per cent in the core CPI). conditions in the economy (Chart II.15b). On the other hand, the contributions of housing and After abstracting the effects of generally volatile education sub-groups to core inflation in the financial items, i.e., food, fuel, petrol, diesel, gold and silver, year so far have been lower than in the pre-pandemic core inflation rose from 5.1 per cent in February to 5.5 period (Chart II.14). per cent in August, attesting to persistence (Table II.2). Overall, goods inflation is driving the core, with A decomposition of CPI excluding food, fuel, petrol, petrol and diesel (under the transportation and diesel, gold and silver into goods and services communication sub-group) registering double digit components points to contrasting movements. inflation consecutively since July 2020. Even as the one-off effects of indirect taxes instituted in the post- Inflation in the goods component (with a weight of lockdown period waned from June 2021, the sustained 20.7 per cent in CPI) has been undergoing consecutive increase in international crude oil prices – by around increases from August 2020, reaching 6.5 per cent in 104 per cent between end-May 2020 and end-August August 2021. This was driven primarily by clothing 2277Monetary Policy Report October 2021 Chart II.15: Petrol and Diesel Prices a: Petrol and Diesel Inflation (y-o-y) b: Petrol Price Build-up* *: IOCL Delhi prices. Sources: PPAC; NSO; Ministry of Commerce and Industry; and RBI staff estimates. and footwear, health care – particularly medicines (Chart II.16a). On the other hand, services inflation – household goods like utensils, washing soap/ (with a weight of 23.0 per cent in CPI) which was at powder, furniture, personal care items and toiletries 4.3 per cent in February, firmed up moderately to 4.5 Chart II.16: Contributions to CPI Inflation excluding Food, Fuel, Petrol, Diesel, Gold and Silver a: Goods b: Services Note: Figures in parentheses indicate weights in CPI. Sources: NSO; and RBI staff estimates. 2288Chapter II Prices and Costs per cent in August 2021. The contribution of services, Table II.3: Trimmed Mean Measures of on an average, to core inflation was somewhat lower Inflation (y-o-y) than what was seen in the pre-pandemic period Period 5% 10% 25% Weighted trimmed trimmed trimmed Median (Chart II.14). A recovery in housing rentals along with Jun-19 3.0 3.1 3.0 2.8 rising education services inflation from the post- Sep-19 3.3 3.2 3.1 2.8 lockdown historic lows are the key drivers for the Dec-19 4.4 4.0 3.7 4.0 uptick in core services inflation between February Mar-20 Jun-20 5.8 5.4 5.1 4.9 and August 2021, apart from medical as well as Sep-20 6.2 5.6 4.7 5.1 household services (Chart II.16b). Dec-20 5.6 5.1 4.3 4.0 Jan-21 5.0 4.8 4.0 3.6 In order to filter noise from CPI inflation and get Feb-21 5.1 4.9 4.1 3.7 to the underlying inflation dynamics two common Mar-21 approaches are (i) excluding a fixed set of components Apr-21 from the CPI basket that display volatile price May-21 Jun-21 5.7 5.2 5.0 5.2 movements and are likely to be transitory; and (ii) Jul-21 5.8 5.3 5.0 4.6 excluding different components each month if they Aug-21 5.5 5.1 4.9 4.3 are located in the tails of the inflation distribution. Sources: NSO; and RBI staff estimates. The exclusion-based measures show heightened inflationary pressures over the last six months 2011-12=100) in May from a sharp and broad-based with no decisive signs of softening (Table II.2). upsurge in price momentum in an environment of Inflation measured by trimmed means, on the other adverse base effects. WPI inflation moderated in hand, shows some edging down of the underlying June and July 2021, despite positive price pressures, inflation pressures in August from the June-July peak owing to base effects turning favourable, although it (Table II.3). remained in double digits. In August, WPI inflation Other Measures of Inflation reversed course and edged up to 11.4 per cent primarily on account of an increase in non-food Over the last 14 months, inflation in sectoral CPIs manufactured products inflation, despite softening for agricultural labourers (CPI-AL) and rural labourers of food inflation. In line with WPI inflation, the (CPI-RL) has remained below CPI headline inflation. Lower food inflation, paired with their higher weights deflators for gross value added (GVA) and gross in CPI-AL and CPI-RL contributed to the lower CPI- domestic product (GDP) edged up sharply between AL and CPI-RL inflation prints. Inflation in terms of Q3:2020-21 to Q1:2021-22. the CPI for industrial workers (CPI-IW) fell below the WPI inflation has averaged 11.7 per cent during April- headline during May-August 2021. August 2021, remaining markedly above CPI inflation WPI inflation registered sharp increases sequentially (average of 5.5 per cent) (Chart II.17a). Inflation in between February and May 2021 to touch an all- petroleum products – especially petrol and diesel – eggs time high of 13.1 per cent (as per the WPI series, and edible oils diverged considerably between the CPI 2299Monetary Policy Report October 2021 Chart II.17: Alternative Measures of Inflation a: Various Measures of Inflation (y-o-y) b: CPI-WPI Divergence: Select Commodities (Average during March 2021 - August 2021) Sources: NSO; Labour Bureau; Ministry of Commerce and Industry; and RBI staff estimates. and the WPI (Chart II.17b). These developments have WPI inflation to the CPI and their long-run relationship again brought to fore the possibility of transmission of (Box II.2). Box II.2: CPI-WPI Inflation Post-Lockdown: Long-run Cointegration and Short-run Error Correction Since the onset of the pandemic in 2020, consumer Chart II.2.1: CPI WPI Inflation price and wholesale price inflation rates have been exhibiting considerable divergence, the wedge widening to 6.1 percentage points in August 2021 (Chart II.2.1). This brought to fore the concern – will elevated WPI inflation feed into CPI? Recent studies have shown that over time and through the course of the pandemic the sensitivity of CPI inflation to WPI inflation has come down (RBI, 2021). An analysis based on CPI and WPI for the period, April 2012-July 2021, shows that a long-run relationship exists between CPI and WPI14. The speed of adjustment is low. Sources: NSO; Ministry of Commerce and Industry; and RBI staff estimates. The CPI food index and the WPI food index are cointegrated as well as homogeneous, i.e., they move one-on-one in cointegrated but the long run coefficient is less than one. the long term. CPI core and WPI core are also found to be While WPI core largely comprises of basic and intermediate (Contd.) 14 The long-run relationship between headline CPI and WPI inflation has been disrupted by the pandemic and it holds only after controlling for the pandemic related disruptions. 3300Chapter II Prices and Costs Table II.2.1: Cointegration and VECM Estimates for CPI and WPI by Major Groups Overall Food@ Fuel@ Core@ Johansen Cointegration Test Trace Statistic 33.00*** 26.74*** 2.74 30.83** H: No Cointegrating Equation (p-value)# (0.005) (0.005) (0.97) (0.01) 0 Number of cointegrating vectors 1 1 0 1 Long-run equation Not Applicable Homogeneity (0.000)*** (0.989) Not Applicable (0.000)*** H: Long run coefficient =1 (p-value) 0 Error correction term in short-run -0.083*** -0.089** Not Applicable -0.078*** Regression Diagnostics: Adjusted R2 0.211 0.317 Not Applicable 0.430 Breusch-Godfrey LM Test (p-value) 0.213 0.238 Not Applicable 0.112 Conclusions Cointegrated; not Cointegrated; and Not Cointegrated Cointegrated; not homogeneous homogeneous homogeneous @ See notes for definitions. # Maximum eigenvalue statistic gives similar results as Trace statistic. *** denotes significance at 1 per cent level, ** denotes significance at 5 per cent level and * denotes significance at 10 per cent level. Notes: 1. The sample period for the analysis is April 2012-July 2021. The estimates on cointegration and vector error correction models (VECMs) are based on Johansen System Cointegration test. The homogeneity is tested using student’s t-test. 2. CPI food is defined as CPI food and beverages. WPI food comprises of WPI food articles, manufactured food products and non-alcoholic beverages. 3. CPI fuel comprises of CPI fuel and light, petrol and diesel. WPI fuel is defined as WPI fuel and power. 4. CPI core is defined as CPI excluding food, fuel, petrol, diesel and housing. WPI core is defined as WPI non-food manufactured products excluding non-alcoholic beverages. 5. COVID-19 related disruptions have been adjusted for by introducing time dummies in the VECMs – a dummy for April 2020 has been included in all four equations and additionally for May 2021 for the core equation. All dummies were found to be significant at 1 per cent level. WPI and CPI with appropriate lags have been included in estimating the short-term error correction equations. References: industrial inputs that do not find representation in CPI, CPI core comprises of household goods and services, including RBI (2021), “State of the Economy”, RBI Bulletin, June 2021. housing service, that are not part of WPI (Das and George, Das, P., & George, A. T. (2017), “Comparison of Consumer 2017). WPI and CPI fuel groups, on the other hand, are not and Wholesale Prices Indices in India: An Analysis of cointegrated (Table II.2.1). Properties and Sources of Divergence”, RBI Working Paper Series, WPS (DEPR): 05 / 2017. II.3 Costs The increase in farm input price inflation was largely driven by double digit inflation in fodder, due to During H1:2021, costs, as measured by inflation damage to production from excess rains during in WPI industrial raw materials and farm inputs, September-October 2020, and HSD reflecting firming increased (Chart II.18). The firming up of global up of global crude oil prices. Fertiliser prices, on a crude oil prices during 2021 impacted the prices of year-on-year basis, edged up moderately during 2021, inputs such as high-speed diesel (HSD), naphtha, reflecting increase in international prices. Prices of aviation turbine fuel (ATF), and furnace oil. Prices of non-food articles also increased during March- electricity – a key input in both industrial and farm August 2021. Prices of fibres and oilseeds edged up inputs – remained muted during H1:2021. Price as international cotton and soybean prices increased. increase of agricultural machinery and implements, However, inflation in industrial raw materials eased on a year-on-year basis, also stayed subdued, although marginally in July 2021 reflecting easing in prices of a gradual pass-through of higher manufacturing costs minerals, bitumen, paper and pulp, before picking due to rising commodity prices is underway during up again in August 2021. March-August 2021. 3311Monetary Policy Report October 2021 rates of the nominal rural wages eased sharply, on a Chart II.18: Farm and Non-farm Input Costs (y-o-y) year-on-year basis, during May-July 2021, attributable to adverse base effects15 (Chart II.19). Growth in the value of production in the organised sector decelerated in contrast to the increase in staff costs for listed firms in the manufacturing sector during Q1:2021-22. In the services sector, staff cost increased sharper than the value of production. As a result, unit labour costs (measured as a ratio of staff cost to value of production) rose from 5.7 per cent in Q4:2020-21 to 6.2 per cent in Q1:2021-22 for firms in the manufacturing sector16 and from 29.1 per cent *: Comprise primary non-food articles, minerals, coal, aviation turbine fuel, high speed diesel, naphtha, bitumen, furnace oil, lube oil, petroleum coke, electricity, to 31.5 per cent for firms in the services sector17 cotton yarn and paper and pulp from WPI. $: Comprise high speed diesel, fodder, electricity, fertilisers, pesticides, and (Chart II.20). agricultural and forestry machinery from WPI. Sources: Ministry of Commerce and Industry; and RBI staff estimates. Input cost pressures and salary outgoes are expected to rise in Q3:2021-22 for the manufacturing firms Nominal rural wages for both agricultural and non- polled in the Reserve Bank’s industrial outlook agricultural labourers remained stagnant; growth survey. Manufacturers may pass on the cost burden Chart II.19: Wage Growth (y-o-y) and Inflation in Rural Areas (y-o-y) Sources: NSO; Labour Bureau; and RBI staff estimates. 15 Rural wages had increased sharply during May-June 2020 reflecting labour shortages during the nationwide lockdown period and the hike in wages by `20 under the Mahatma Gandhi National Rural Employment Guarantee (MGNREGA) scheme effective April 1, 2020. 16 Based on 1,647 manufacturing firms. 17 Based on 661 services firms. 3322Chapter II Prices and Costs going forward. The firms expect these factors to push Chart II.20: Labour Cost in Manufacturing and up the selling prices in Q3 along with increase in Services Staff Cost Per Unit Value of Production salary outgoes (Chart II.21b). An analysis of the composition of costs among listed non-government non-financial (NGNF) firms18 reveals that there has been a distinct upward shift in costs for all constituents since the pre-pandemic period (Chart II.22). Manufacturing firms included in the purchasing managers’ index (PMI) also reported increase in input prices, with the pace of increase picking up in September 2021. PMI services firms reported elevated input prices, mainly driven by fuel, raw materials and Sources: Capitaline database; and RBI staff estimates. transportation. In tandem, selling prices also started and selling prices are expected to increase in Q3 to tick up, though the pace remained muted. One (Chart II.21a). year ahead business inflation expectations polled by The firms covered in the Reserve Bank’s services and the Indian Institute of Management, Ahmedabad, infrastructure outlook survey also expect input cost rose to their highest reading in July before softening pressures as also the cost of finance to harden further somewhat in August.19 Chart II.21: Expectations of Cost Condition a: Manufacturing Firms’ Cost (expectation) b: Services Firms’ Cost (Expectations) Sources: Reserve Bank's Industrial Outlook Survey; Reserve Bank's Services and Infrastructure Outlook Survey; and RBI staff estimates. 18 Based on the abridged quarterly financial results of common companies. 19 The monthly Business Inflation Expectations Survey (BIES) of the Indian Institute of Management, Ahmedabad, polls a panel of around 1200 business leaders primarily from the manufacturing sector about their inflation expectations in the short and medium term. The latest survey pertains to July 2021. 3333Monetary Policy Report October 2021 may be shifting downwards in contrast to initial Chart II.22: Cost of Manufacturing Firms expectations. Active supply-side interventions by the Government in food items, particularly in pulses and edible oils, should bring about a better balance between supply and demand. With cost pressures showing no sign of abating, core inflation remains sticky and elevated. Furthermore, shortage of key industrial components due to stretched global supply chains and logistics is also leading to cost escalation. As demand recovery gathers steam, there is a rising risk of higher input price pass-through to output prices. Measures to ameliorate supply-side cost pressures would be critical at this juncture, especially in terms of a calibrated reduction of the Sources: Capitaline database; and RBI staff estimates. indirect taxes on petrol and diesel. This would help anchor inflation expectations, prevent build-up of II.4 Conclusion a wage-price nexus and provide space for monetary With inflation expected to moderate in near policy to sustain support for the still incomplete months, the outlook has improved, and its trajectory growth recovery. 3344Chapter III Demand and Output III. Demand and Output While the second wave dented the momentum of economic activity in Q1:2021-22, its impact on aggregate demand was muted relative to the first wave. Aggregate demand recovered in Q2:2021-22 and is expected to strengthen further in H2. The supply side is gradually normalising with the easing of supply chain and logistic disruptions. The recovery, however, remains dependent upon continued policy support, the COVID-19 trajectory and the progress of vaccination. Within days of the release of April 2021 MPR, the was muted and short-lived relative to the first second wave of COVID-19 intensified and became wave. More nuanced and calibrated containment virulent and lethal, overwhelming the health measures and adaptation by businesses and infrastructure and denting the momentum of households to working in a pandemic environment economic activity in Q1:2021-22. The second wave also moderated the headwinds from the second receded as rapidly as it had surged (Chart III.1). wave. Aggregate demand recovered further in Q2:2021- Accordingly, the impact on aggregate demand 22, led by investment and private consumption. Chart III.1: COVID Infections and Vaccination a: New Cases b: Fatalities and Recovery Rate (7-day moving average) (7-day moving average) c: Daily Vaccinations d: Cumulative Vaccination Status (7-day moving average) (month-end) Source: Ministry of Health and Family Welfare (MoH&FW). 35Monetary Policy Report October 2021 Table III.1: Real GDP Growth (y-o-y per cent) Item 2019-20 2020-21 Weighted 2019-20 2020-21 2021-22 (FRE) (PE) contribution* 2019-20 2020-21 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 PFCE 5.5 -9.1 3.1 -5.2 7.6 6.5 6.4 2.0 -26.2 -11.2 -2.8 2.7 19.3 (-11.9) GFCE 7.9 2.9 0.8 0.3 1.8 9.6 8.9 12.1 12.7 -23.5 -1.0 28.3 -4.8 (7.4) GFCF 5.4 -10.8 1.7 -3.5 13.3 3.9 2.4 2.5 -46.6 -8.6 2.6 10.9 55.3 (-17.1) Exports -3.3 -4.7 -0.7 -0.9 3.0 -1.3 -5.4 -8.8 -21.8 -2.0 -3.5 8.8 39.1 (8.7) Imports -0.8 -13.6 -0.2 -3.1 9.4 -1.7 -7.5 -2.7 -40.9 -17.9 -5.0 12.3 60.2 (-5.3) GDP at market prices 4.0 -7.3 4.0 -7.3 5.4 4.6 3.3 3.0 -24.4 -7.4 0.5 1.6 20.1 (-9.2) Note: *: Component-wise contributions to growth do not add up to GDP growth because change in stocks, valuables and discrepancies are not included. Figures in parentheses are growth rates over Q1:2019-20. FRE: First revised estimates, PE: Provisional estimate Source: National Statistical Office (NSO). The recovery is benefitting from pent-up demand sowing. A number of high-frequency indicators are supported by the increasing vaccination coverage, yet to exceed the pre-COVID levels, however, and the the government’s push towards capital expenditure, recovery remains dependent upon continued policy robust external demand and normal monsoon. The support. ongoing demand revival is expected to get a further III.1 Aggregate Demand boost from the government’s asset monetisation programme and reforms encompassing the telecom Despite a loss of momentum in the wake of the and banking sectors. The supply side is also gradually severe second wave, real gross domestic product normalising with the easing of supply chain and (GDP) rose by 20.1 per cent year-on-year (y-o-y) logistic disruptions. Agriculture and allied activities in Q1:2021-22 on a large favourable base effect remain resilient, backed by above normal kharif (Table III.1 and Chart III.2a), supported by expansion Chart III.2: GDP Growth and its Constituents a. Weighted Contribution of the Components t o b: GDP Growth and Momentum GDP Growth Note: SAAR – Seasonally adjusted annualised rate. Sources: NSO and RBI staff estimates. 36Chapter III Demand and Output in all its constituents except for government final baseline growth path. The decline in the government consumption expenditure (GFCE) which contracted. consumption expenditure also contributed to actual The level of GDP in Q1:2021-22 was, however, still 9.2 GDP growth trailing projections. per cent below the pre-pandemic (Q1:2019-20) level. III.1.1 Private Final Consumption Expenditure Excluding GFCE, real GDP expanded by 25.0 per cent Private consumption, with a share of around 55 per cent (y-o-y) during Q1. Momentum – the quarter-on-quarter in GDP during Q1:2021-22, continued as the mainstay (q-o-q) seasonally adjusted annualised rate (SAAR) of of aggregate demand. Notwithstanding a y-o-y growth real GDP – fell during Q1:2021-22, however, reflecting of 19.3 per cent, it was around 12 per cent lower than the lockdowns/restrictions during the second wave, its pre-COVID level (Q1:2019-20). The accelerated pace although the contraction was lower than a year ago of vaccination and the plateauing of new infections with businesses and households adapting better to are facilitating faster resumption of contact-intensive COVID-19 protocols as well as the sharp tapering in services and giving a fillip to private consumption. infections (Chart III.2b). Aggregate demand gained Urban demand is turning the corner as corroborated by momentum in Q2, supported by recovery in private high frequency coincident and leading indicators for consumption and investment demand. Q2. Passenger vehicle sales in July and August crossed GDP Projections versus Actual Outcomes pre-COVID levels (Chart III.4a), but production is Actual real GDP growth of 20.1 per cent in Q1 facing headwinds from the persistence of global supply undershot the April 2021 MPR projection of 26.2 per bottlenecks in the availability of semiconductor chips. cent (Chart III.3), largely reflecting the impact of the Domestic air passenger traffic and the production of steep jump in infections due to the second wave. consumer durables regained traction during July and The April MPR had alluded to the potential surge in August, albeit they are still below pre-COVID levels infections and new mutants as downside risks to the (Chart III.4b and c). Household credit is gradually improving, driven by credit card transactions and Chart III.3: GDP Growth: Projection versus Actual personal loan, supporting consumer durables (Q1: 2021-22) financing (Chart III.4d). Digital retail payments data, which provide useful signals of economic activity, corroborate the upturn (Box III.1). Rural consumption demand, which was largely immune to the pandemic during the first wave, was dented during the second wave with the fast spread of infections to rural areas. With the abatement of the second wave and improving vaccinations, rural consumption exhibited recovery in Q2, backed by buoyant rabi harvest, good kharif prospects, government transfers and the Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA) programme. The pick-up in motorcycle sales during June-August and the improvement in consumer Sources: NSO and RBI staff estimates. non-durables underscore this revival (Chart III.5). 37Monetary Policy Report October 2021 Chart III.4: Urban Demand: High Frequency Indicators a: Passenger Vehicle Sales b: Domestic Air Passenger Traffic c: Consumer Durables d: Household Credit Sources: Directorate General of Civil Aviation (DGCA), Society of Indian Automobile Manufacturers (SIAM); NSO; and RBI. Tractor sales have exhibited robust growth, remaining 2019 levels, although trailing the exceptionally strong above their pre-pandemic levels, although sales dipped growth of last year. in August in the usual seasonal pattern. Fertiliser Unemployment rose and labour force participation sales picked up from May, moving in tandem with fell in Q1:2021-22 under the pressure of the second Box III.I: Tracking Macroeconomic Activity using Digital Payments Data A robust assessment of the current state of the economy macroeconomic forecasting tools to nowcast economic and its expected trajectory is critical for the effectiveness activity has become widespread. In this regard, payments of a forward-looking monetary policy. Data on GDP – data represent a unique source of tracing the underlying the comprehensive measure of economic activity – are economic activity, given their crucial role in undertaking however, available, with a lag of two months after the end and settling transactions in a market economy. Cross- of the reference quarter. Given these data lags and the large country empirical evidence suggests that the payments and swift exogenous shocks that have been witnessed in data enhance the accuracy of the nowcasts and short-term the recent years (such as the 2008 global financial crisis forecasts relative to other indicators (Aprigliano et. al., and the ongoing COVID-19 pandemic), the interest in new 2019; Bentsen et. al., 2021). (Contd.) 38Chapter III Demand and Output India has state-of-the-art payments infrastructure and Chart III.I.1: Economic Activity Forecasts products and there is a wider adoption of digital payments and Payments Data (Das, 2021). The share of digital transactions in the total volume of non-cash retail payments stood at 98.5 per cent during 2020-21. The width and the depth of the banking system, the enhanced policy focus on promoting digital payments and the relatively quick availability of such data make them valuable for nowcasting GDP in the Indian context. A preliminary analysis shows that, amongst the various modes of digital retail payments, the volume of transactions through the following three channels – ATMs, credit cards and debit cards – has a Notes: Model 1: digital payments only; Model 2: digital payments plus petroleum consumption, electricity consumption and railway freight traffic; high correlation with GDP (0.95 for the period Q1:2011- Model 3: Petroleum consumption, electricity consumption and railway freight traffic; AR(1): Autoregressive model (first-order). 12 to Q4:2020-21). The dynamics are further explored Source: RBI staff estimates. through alternate autoregressive distributed lag (ARDL) model specifications with the following variables: real data (Model 1) outperform the specification which does GDP, digital payments volumes (as defined above), and not include payments data (Model 3) and also upon the select real economy indicators having a strong association benchmark AR(1) model (Chart III.1.1). Payments data with output (namely, petroleum consumption, electricity thus add value to the forecasting toolkit and mixed consumption and railway freight traffic) as control frequency modelling approaches can provide monthly variables1. updates of the evolving output dynamics. The fast pace To assess the role of the payments data relative to of the innovations in the payments technology and the the competing variables, three model specifications rapid shifts in the payments habits of economic agents are attempted. Model 1 includes data only on digital need ongoing refinements in the modelling approaches. payments; Model 2 augments payments data with the References: control variables; Model 3 drops the payments data Aprigliano, V., G. Ardizzi and L. Monteforte (2019), “Using and includes only the three control variables. Given Payment System Data to Forecast Economic Activity”, the large disruptions to the economic activity from the International Journal of Central Banking, 15(4), 55-80. unprecedented COVID-19 pandemic and to evaluate the relative forecasting performance, the models are estimated Bentsen, K.N., D. Gorea (2021), “Nowcasting and initially for the pre-COVID period (Q2:2011-12 to Q3:2019- Forecasting Economic Activity in Denmark using Payment 20) and subsequently for the sample including the COVID System Data”, Denmark Nationalbank Working Paper. period (Q2:2011-12 to Q4:2020-21). The estimates indicate Das, Shaktikanta (2021). Financial Inclusion – Past, that the forecasts of the baseline model with payments Present and Future, RBI Bulletin, August. 1 Unit root tests suggest that all variables are non-stationary (I(1)). Bounds test (F-statistics) confirm cointegration for all the specifications at 5 per cent significance level. Data are in log terms and adjusted for seasonality; the variable lags are based on the Bayesian information criterion (BIC) and the regression diagnostics are satisfied. 39Monetary Policy Report October 2021 Chart III.5: Rural Demand: High Frequency Indicators a: Tractor Sales b: Motorcycle Sales c: Consumer Non-durables d: Fertiliser Sales Sources: Tractor Manufactures Association; Society of Indian Automobile Manufacturers (SIAM); NSO; and Ministry of Chemicals and Fertilisers. wave, but the impact was muted compared to the also shown strong recovery recently, according to first wave. According to the Centre for Monitoring Naukri Jobspeak data. Indian Economy (CMIE), there was a deep hit to III.1.2 Gross Fixed Capital Formation labour markets in mid-May at the peak of the second Gross fixed capital formation (GFCF) expanded by wave. Employment recovered swiftly in June-July 55.3 per cent (y-o-y) in Q1 (contraction of 46.6 per and strengthened in September (Chart III.6a). In cent a year ago). Sequentially, there was a dip of 23.6 September, labour participation further rose with per cent in Q1 despite robust government capex. the phased opening up of the economy leading to The share of GFCF in aggregate demand inched up rising demand for labour. Employment conditions to 31.6 per cent in Q1 from 24.4 per cent a year ago improved in June and July 2021 in the organised but remained lower than its pre-pandemic level. sector, according to payrolls data (Chart III.6b). Construction activity, a large portion of GFCF, was Increase in hirings is led by the IT sector, while subdued due to pandemic effects, especially led by non-IT sectors such as education, banking, financial, labour and materials shortages, although the impact insurance, hospitality and automobile sector have was less than during the first wave. There are signs of 40Chapter III Demand and Output Chart III.6: Employment Situation in India a: Unemployment and Labor Participation Rates b: Net Payroll Additions based on EPFO Records Sources: CMIE; and Employees’ Provident Fund Organisation (EPFO). revival in investment demand in Q2, as suggested by goods imports; production of capital goods; and the movements in the proximate indictors – capital cement production (Charts III.7). Chart III.7: Indicators of Investment Demand a: Import of Capital Goods b: IIP Capital Goods c: Finished Steel Consumption d: Cement Production Sources: DGCI&S; NSO; Joint Plant Committee; and Office of Economic Adviser. 41Monetary Policy Report October 2021 Capacity utilisation (CU) in the manufacturing sector Chart III.9: Interest Coverage Ratio in dropped to 60.0 per cent in Q1:2021-22 from 69.4 Manufacturing and Services Firms per cent in the previous quarter (Chart III.8). On a seasonally adjusted basis, CU fell from 66.7 per cent in Q4 to 61.7 per cent in Q1. The interest coverage ratio (ICR)2 of listed non- financial private companies in the manufacturing and information technology (IT) sectors improved further in Q1:2021-22, indicating improved debt servicing capacity and hence, conducive conditions for the expansion in investment activity (Chart III.9). The production-linked incentive (PLI) scheme is nurturing private investment. The mega schemes, Note: Data for Q1:2021-22 are based on results of 1,647 listed private manufacturing companies and 661 listed private non-finacial services viz. National Infrastructure Plan (NIP) amounting to companies. `100 lakh crore and National Monetisation Pipeline Source: RBI staff estimates. (NMP) involving `6 lakh crore (Chart III.10), are also expected to give a major thrust to infrastructure and by leveraging further public investments. The spending and uplift potential output. The NMP, central government’s financial assistance to the which will be co-terminus with the balance NIP state governments for infrastructure spending and period (2021-22 to 2024-2025), is expected to unlock incentives for disinvestment/monetisation in the the value of investments in brownfield public sector form of additional allocation equivalent to 33 per assets by tapping institutional and long-term capital cent of value of the monetised assets, subject to the Chart III.8: Capacity Utilisation in Manufacturing Chart III.10: National Monetisation Pipeline Sources: Ministry of Finance and Press Information Bureau (PIB), Government Source: RBI. of India. 2 Interest coverage ratio is the ratio of earnings before interest and taxes (EBIT) to interest expenses and measures a company’s capacity to make interest payments on its debt. 42Chapter III Demand and Output Table III.2: Budgetary Position of the Central Government Item (` thousand crore) (Per cent) Budget estimates Actuals Per cent to BE Growth rate 2020-21 2021-22 Apr-Aug 2020 Apr-Aug 2021 Apr-Aug 2020 Apr-Aug 2021 Apr-Aug 2020 Apr-Aug 2021 1. Revenue receipts 2,020.9 1,788.4 370.6 793.5 18.3 44.4 -38.6 114.1 2. Tax revenue (Net) 1,635.9 1,545.4 284.5 644.8 17.4 41.7 -29.7 126.7 3. Non-tax revenue 385.0 243.0 86.1 148.7 22.4 61.2 -56.6 72.6 4. Non-debt capital receipts 225.0 188.0 6.7 15.2 3.0 8.1 -63.5 127.8 5. Total receipts (1+4) 2,245.9 1,976.4 377.3 808.7 16.8 40.9 -39.3 114.3 6. Total expenditure (7+8) 3,042.2 3,483.2 1,247.7 1,276.7 41.0 36.7 6.2 2.3 7. Revenue expenditure 2,630.1 2,929.0 1,113.2 1,104.8 42.3 37.7 7.1 -0.8 8. Capital expenditure 412.1 554.2 134.4 171.9 32.6 31.0 -1.3 27.8 9. Revenue deficit (7-1) 609.2 1,140.6 742.6 311.3 121.9 27.3 70.3 -58.1 10. Gross fiscal deficit (6-5) 796.3 1,506.8 870.3 468.0 109.3 31.1 57.1 -46.2 11. Gross primary deficit 88.1 697.1 632.7 189.6 717.9 27.2 89.0 -70.0 Source: Controller General of Accounts (CGA). realised amount being used for capital expenditure, were lower than past trends (Table III.2). Though should also provide an impetus to capital expenditure. the first supplementary demands for grants for 2021-22 presented in July involved gross additional III.1.3 Government Expenditure expenditure of `1,87,202 crore, the net cash outgo Government final consumption expenditure (GFCE) amounts to only `23,675 crore or 0.12 per cent of GDP. contracted by 4.8 per cent in Q1:2021-22, partly due to the base effect. Revenues – both tax and non-tax The buoyancy in the central government’s tax – remained robust. The fiscal position of the central revenue during April-August 2021 was driven government accordingly strengthened during April- by higher corporate taxes (on the back of strong August 2021 and the gross fiscal deficit (GFD) and corporate performance) and customs duties (due to the revenue deficit (RD) at 31.1 per cent and 27.3 higher import demand and improving trade activity) per cent of the budget estimate (BE), respectively, (Table III.3). Excise duty collections benefitted from Table III.3: Central Government’s Tax Collections Item ` thousand crore Per cent Budget Estimates Actuals Per cent to BE Growth Rate 2020-21 2021-22 Apr-Aug 2020 Apr-Aug 2021 Apr-Aug 2020 Apr-Aug 2021 Apr-Aug 2020 Apr-Aug 2021 A. Direct taxes 1,319.0 1,108.0 187.3 376.2 14.2 34.0 -33.3 108.0 Of which 1. Corporation tax 681.0 547.0 64.7 168.1 9.5 30.7 -41.8 159.7 2. Income tax 625.0 548.5 117.7 199.4 18.8 36.4 -28.9 69.3 B. Indirect Taxes 1,104.0 1,109.1 316.9 483.4 28.7 43.6 -16.6 52.6 Of which 1. Total GST 693.5 633.3 182.4 266.9 26.3 42.1 -23.9 46.3 2. Custom duties 138.0 136.0 32.3 76.2 23.4 56.0 -47.9 136.0 3. Union excise duties 267.0 335.0 100.4 137.2 37.6 41.0 32.0 36.7 C. Gross tax revenue 2,423.0 2,217.1 504.2 859.6 20.8 38.8 -23.7 70.5 D. Assignment to States/UTs 784.2 665.6 218.0 212.6 27.8 31.9 -14.7 -2.5 E. Net tax revenue 1,635.9 1,545.4 284.5 644.8 17.4 41.7 -29.7 126.7 Sources: Union Budget Documents and Controller General of Accounts. 43Monetary Policy Report October 2021 Chart III.11: GST Collections Chart III.12: States' Fiscal Indicators during April-July Sources: CGA and PIB. Source: Comptroller and Auditor General of India. higher global crude oil prices. Goods and services crore people under the Pradhan Mantri Garib Kalyan tax (GST) collections received a jolt from the second Anna Yojana to mitigate the impact of COVID-19. The wave during May and June but recovered rapidly in central government’s capital expenditure increased the subsequent period (Chart III.11). Overall, direct by 27.8 per cent y-o-y during April-August 2021 (and taxes rose by 101.4 per cent y-o-y (32.8 per cent over 26.2 per cent over pre-COVID level), driven by outlays the corresponding period of 2019-20), while indirect towards road transport and highways. taxes surged by 52.5 per cent (27.2 per cent over the Available information for 18 states indicates that corresponding period of 2019-20). Non-tax revenue their GFD in April-July 2021 (as per cent to full year also registered healthy growth, boosted by higher budget estimates) was lower than a year ago on the surplus transfer by the Reserve Bank. back of a surge in revenue receipts led by own tax On the expenditure side, revenue expenditure and non-tax revenues, even as transfers from the contracted marginally by 0.8 per cent y-o-y during Centre contracted (Chart III.12).3 Subsequent to April-August 2021 (although higher by 6.3 per cent the 43rd meeting of the GST Council, it was decided over the pre-pandemic level), partly due to the that the Centre would borrow `1.59 lakh crore from frontloading of expenditures a year ago necessitated the market through a special window for 2021-22, by the first wave of the pandemic and also efforts which would be passed on to states as back to back to curtail avoidable spending. Spending on major loans; of this, an amount of `75,000 crore has been subsidies, however, increased by 12.8 per cent y-o-y transferred to states. Furthermore, `81,179 crore of (lower by 22.2 per cent compared to the same period the GST compensation overdues of the last year are of 2019-20), with the extension of the schemes put in also expected to be transferred this year. Both revenue place last year to provide free ration to more than 80 and capital expenditure of the states picked up during 3 Following the deterioration in key fiscal indicators in 2020-21, 27 states budgeted a lower consolidated GFD at 3.4 per cent of GDP for 2021-22, driven by higher revenues. 44Chapter III Demand and Output Table III.4: Government Market Borrowings (` crore) Item 2019-20 2020-21 2021-22 (up to end-September) Centre States Total Centre States Total Centre States Total Net borrowings 4,73,972 4,87,454 9,61,426 11,43,114 6,51,777 17,94,891 5,63,100 2,35,741 7,98,841 Gross borrowings 7,10,000 6,34,521 13,44,521 13,70,324 7,98,816 21,69,140 7,02,357 3,08,972 10,11,329 Sources: Government of India; and RBI staff estimates. April-July 2021 – the latter expanded sharply by 99 per III.1.4 External Demand cent, more than offsetting the contraction of 45 per Buoyed by strong external demand and base effects, cent a year ago. exports registered a sharp expansion in Q1:2021- The Union Budget 2021-22 projected gross and net 22 and the buoyancy continued to Q2 (Chart III.13). market borrowings at `12.05 lakh crore and `9.24 Merchandise imports also rebounded strongly on the lakh crore, respectively. The centre’s gross issuances back of the recovery in domestic demand, higher crude of market borrowings during the first half were `7.02 oil prices and base effects. With the growth of imports lakh crore (58.3 per cent of the full year budgeted outpacing that of exports, net exports contributed amount) as against `7.24 lakh crore envisaged in the negatively to aggregate demand in Q1:2021-22 [(-)1.9 calendar for H1 (Table III.4). The weighted average per cent in Q1 as compared with 1.3 per cent a year cost and maturity of issuances during H1:2021-22 ago and (-) 4.8 per cent two years ago (pre-COVID)]. were 6.19 per cent and 16.7 years, respectively (5.8 The surge in merchandise exports was powered per cent and 14.8 years in the same period of 2020-21). by engineering goods, petroleum products, organic For H2:2021-22, the centre’s gross market borrowings and inorganic chemicals, cotton textiles and drugs have been planned `5.03 lakh crore in line with the and pharmaceuticals. Labour-intensive sectors like full year budget estimates. Against the backdrop of comfortable cash position, the Central Government has not planned additional market borrowing for Chart III.13: Merchandise Trade making payment to the state governments for GST compensation. States raised gross market borrowings of `3.09 lakh crore during H1:2021-22, 83.4 per cent of the indicative calendar. The ways and means advances (WMA) limit for the Central Government for H1:2021-22 was scaled back to `1.2 lakh crore from `2 lakh crore in H1:2020-21; for H2:2021-22, it has been fixed at `0.5 lakh core as compared with `1.25 lakh core a year ago. For states/union territories, the Reserve Bank decided to continue with the enhanced interim WMA limit of `51,560 crore during the first half of 2021-22 to help them in tiding over the short-term mismatches and Source: DGCI&S. difficulties faced due to the pandemic. 45Monetary Policy Report October 2021 Chart III.14: Exports Growth a: Exports Growth Relative Contribution b: Major Drivers of Exports in April-August 2021: Relative Contribution Sources: DGCI&S and CPB, Netherlands. apparels, leather products and tea continue to lag, restrictions (Chart III.15). The trade deficit widened mainly due to their greater sensitivity to mobility to US$ 55.5 billion in April-August 2021 from US$ restrictions (Chart III.14). Going forward, the schemes 23.4 billion a year ago, but it remained below its pre- such as District as Export Hub (DEH) covering One COVID level (US$ 77.2 billion). District One Product (ODOP), PLI scheme for sunrise Services exports growth in Q1: 2021-22 was the sectors and Ubharte-Sitaare scheme for MSMEs should highest in 13 quarters and surpassed pre-pandemic improve export competitiveness and help to achieve levels (Chart III.16). This strong growth in the overall the target of US$ 400 billion set for 2021-22. The services exports was driven by software, business, persistent upsurge in global container freight prices and transportation services. Major information and the growing shortage of semi-conductors, however, technology (IT) companies continued to benefit pose downside risks to a durable merchandise trade from pandemic-induced demand from international recovery (see Chapter V). customers and adoption of new models. They The impact of the second wave on import demand recorded solid revenue growth in Q1:2021-22, driven remained limited as compared to the first wave, by banking, financial services including insurance, reflecting calibrated and localised restrictions and communications, healthcare and technology services. businesses adapting to COVID-appropriate working As a result, resilient services surplus had a favourable environment. In Q2, with the gradual unwinding impact on the current account balance in Q1:2021-22. of restrictions, merchandise imports spurted and During Q2 (July-August 2021), double-digit growth in exceeded pre-COVID levels. Non-oil non-gold imports services exports was driven by software, business and were led by higher shipments of pearls and precious transport services. stones, vegetable oils, chemicals and chemical products. Gold imports, after dropping sharply in May Turning to the financial account, capital flows and June on the back of subdued demand due to the remained healthy during Q1:2021-22, primarily due second wave, revived in Q2 with the relaxations of the to foreign direct investment (FDI), which was driven 46Chapter III Demand and Output Chart III.15: Imports Growth a: Imports Growth Relative Contribution b: Major Drivers of Imports in April-August 2021: Relative Contribution Source: DGCI&S. by a few big deals in the manufacturing and digital macroeconomic indicators. Accretions to non- sectors (Chart III.17). Net FDI at US$ 14.1 billion in resident deposits moderated during April-July 2021 April-July 2021 was higher than a year ago. While as compared with a year ago. As on October 1, 2021, foreign portfolio investors (FPIs) adopted a cautious India’s foreign exchange reserves stood at US$ 637.5 stance during the second wave of COVID-19, billion, equivalent to 14 months of imports projected they turned net buyers from August 2021 amidst for 2021-22 and 111.6 per cent of outstanding robust Q1 corporate earnings and better domestic external debt at end-June 2021. Chart III.16: Services Trade Chart III.17: Net Foreign Direct and Portfolio Investment Notes: *: Net FDI data pertains to July 2021. Sources: National Securities Depository Limited (NSDL) and RBI. Source: RBI. 47Monetary Policy Report October 2021 Table III.5: Sector-wise Growth in GVA (y-o-y growth) Sector 2019-20 2020-21 Weighted 2019-20 2020-21 2021-22 (FRE) (PE) contribution 2019-20 2020-21 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Agriculture, forestry and fishing 4.3 3.6 0.6 0.5 3.3 3.5 3.4 6.8 3.5 3.0 4.5 3.1 4.5 (8.2) Industry -2.0 -6.4 -0.5 -1.4 1.0 -2.7 -3.0 -3.2 -31.0 -1.6 1.6 5.5 40.4 (-3.1) Mining and quarrying -2.5 -8.5 -0.1 -0.2 -1.3 -5.2 -3.5 -0.9 -17.2 -6.5 -4.4 -5.7 18.6 (-1.8) Manufacturing -2.4 -7.2 -0.4 -1.2 0.6 -3.0 -2.9 -4.2 -36.0 -1.5 1.7 6.9 49.6 (-4.2) Electricity, gas, water supply and other utilities 2.1 1.9 0.0 0.0 6.9 1.7 -3.1 2.6 -9.9 2.3 7.3 9.1 14.3 (3.0) Services 6.4 -8.4 4.0 -5.3 6.8 7.3 5.8 5.6 -24.9 -11.0 -0.2 3.2 16.1 (-12.8) Construction 1.0 -8.6 0.1 -0.7 3.7 1.0 -1.3 0.7 -49.5 -7.2 6.5 14.5 68.3 (-14.9) Trade, hotels, transport, communication 6.4 -18.2 1.3 -3.7 6.2 6.8 7.0 5.7 -48.1 -16.1 -7.9 -2.3 34.3 (-30.2) Financial, real estate and professional services 7.3 -1.5 1.6 -0.3 8.8 8.9 5.5 4.9 -5.0 -9.1 6.7 5.4 3.7 (-1.5) Public administration, defence and other services 8.3 -4.6 1.1 -0.6 5.6 8.8 8.9 9.6 -10.2 -9.2 -2.2 2.3 5.8 (-5.0) GVA at basic prices 4.1 -6.2 4.1 -6.2 5.0 4.6 3.4 3.7 -22.4 -7.3 1.0 3.7 18.8 (-7.8) Note: FRE: First revised estimates; PE: Provisional estimates. Figures in parenthesis are growth rates over Q1:2019-20. Source: NSO. III.2 Aggregate Supply to mid-July and almost the whole of August), after a normal start. With the strong revival of rains in Real gross value added (GVA) at basic prices rose by September, the cumulative seasonal rainfall was 0.7 18.8 per cent y-o-y during Q1:2021-22 as against a contraction of 22.4 per cent in Q1:2020-21 (Table Table III.6: Agriculture Production III.5). The resilience of agriculture and the recovery in manufacturing and non-contact intensive Item Lakh tonnes Growth (%) 2019-20 2020-21 2020-21 services supported the expansion in GVA, while over final contact-intensive services lagged due to logistic and estimate 2019-20 operational constraints. Real GVA was, however, 7.8 I. Total foodgrains 2,975.0 3,086.5 3.7 per cent below its pre-pandemic (Q1:2019-20) level. Rice 1,188.7 1,222.7 2.9 Wheat 1,078.6 1,095.2 1.5 III.2.1 Agriculture Coarse cereals 477.5 511.5 7.1 Pulses 230.3 257.2 11.7 Agriculture and allied activities registered robust II. Commercial crops growth in Q1:2021-22 on the back of record rabi Sugarcane 3,705.0 3,992.5 7.8 and horticulture production and resilience in allied Cotton 360.7 353.8 -1.9 Oilseeds 332.2 361.0 8.7 activities. Foodgrains production rose by 3.7 per cent III. Total horticulture crops 3,204.7 3,298.6 2.9 in 2020-21, led by rice and wheat (Table III.6). The III.1 Total fruits 1,020.8 1,027.6 0.7 production of nine major oilseeds increased by 8.7 Banana 326.0 338.3 3.8 Citrus 145.7 140.7 -3.4 per cent, supported by the implementation of area Mango 203.2 208.9 2.8 expansion policies under the National Food Security III.2 Total vegetables 1,882.8 1,962.7 4.2 Onion 260.9 269.2 3.2 Mission for edible oils. Horticulture production rose Potato 485.6 536.9 10.6 by 2.9 per cent during 2020-21, led by an increase of Tomato 205.5 210.0 2.2 2.8 per cent in the area under cultivation. III.3 Plantation crops 161.2 166.0 3.0 III.4 Total spices 101.4 105.4 3.9 In 2021, the south-west monsoon rainfall encountered III.5 Flowers and aromatics 37.3 35.7 -4.3 two slowdown phases (from the third week of June Source: Ministry of Agriculture and Farmers’ Welfare (MOAFW). 48Chapter III Demand and Output per cent below the long period average (LPA), with a year ago, and 4.1 per cent higher than the normal 83 per cent of the sub-divisions receiving normal sown area (5-year average) (Chart III.18d). Higher or above normal rainfall (Charts III.18a and b). The minimum support prices (MSPs) – with increases of production weighted rainfall (PRN) index at 102 1.1 per cent to 6.6 per cent over the previous year for per cent (as on September 30) was below last year’s kharif 2021-22 with assured return of at least 50 per position (105 per cent) and the PRN for rice, coarse cent over the cost of production (as measured by A2 cereals and sugarcane exceeded the 5-year average. As plus FL) – supported sowing activity. According to the on September 30, 2021, reservoir levels stood at 80 first advance estimates for 2021-22, the production of per cent of the full reservoir level (FRL), higher than kharif foodgrains rose by 0.6 per cent over last year the decadal average of 77 per cent – brightening the (Table III.7). The Government of India had set the prospects for the ensuing rabi season (Chart III.18 c). target for foodgrains production for the year at 3,070 Despite the breaks in the monsoon’s progress, kharif lakh tonnes in the National Kharif Strategy for 2021- sowing progressed well. As on September 30, 2021 22 which, inter alia, aims to attain self-sufficiency in it was 0.2 per cent above the record sowing acreage the production of pulses and oilseeds. Chart III.18: Progress of Rainfall and Kharif Sowing a: Cumulative Weekly Progress of South-west Rainfall b: Comparative Rainfall Position c: Reservoir Level d: Kharif Sowing Progress Sources: India Meteorological Department (IMD), Central Water Commission, and Ministry of Agriculture and Farmers' Welfare, Government of India. 49Monetary Policy Report October 2021 III.2.2 Industry Table III.7: Kharif Crops Production 2021-22 (Lakh tonnes) Industrial GVA posted y-o-y growth of 40.4 per cent Item 2020-21 2021-22 2021-22 in Q1:2021-22, aided by a favourable base effect First Fourth First Growth (per cent) (31.0 per cent contraction last year). On a sequential AE AE AE Over Over 1st AE 4th AE basis, industrial output contracted by 11.8 per cent in 2020-21 2020-21 Q1, reflecting the loss of momentum in the face of 1. Foodgrains 1,445.2 1,495.6 1,505.0 4.1 0.6 the second wave. Industrial GVA trailed 3.1 per cent Rice 1,023.6 1,044.1 1,070.4 4.6 2.5 below its pre-pandemic level (Q1:2019-20); while Coarse Cereals 328.4 364.6 340.0 3.5 -6.7 Pulses 93.1 86.9 94.5 1.5 8.7 mining and manufacturing remained below Q1:2019- Tur 40.4 42.8 44.3 9.7 3.5 20 levels, electricity, gas, water supply and other Urad 21.5 16.0 20.5 -4.7 28.1 services exceeded Q1:2019-20 levels by 3.0 per cent Moong 20.9 20.1 20.5 -1.9 2.0 2. Oilseeds (total) 257.3 240.3 233.9 -9.1 -2.7 (Chart III.19). Groundnut 95.4 85.6 82.5 -13.4 -3.5 The index of industrial production (IIP) rose by 44.7 Soyabean 135.8 129.0 127.2 -6.4 -1.4 3. Cotton # 371.2 353.8 362.2 -2.4 2.4 per cent y-o-y during Q1:2021-22 on a negative base but 4. Jute & Mesta ## 96.6 95.6 96.1 -0.5 0.5 remained 6.7 per cent below its level two years back. 5. Sugarcane 3998.3 3992.5 4192.5 4.9 5.0 In Q2, the IIP expanded by 11.5 per cent y-o-y in July #: Lakh bales of 170 kgs each. 2021, although it trailed marginally the pre-pandemic # #: Lakh bales of 180 kgs each. Source: MOAFW. levels (July 2019). Sequentially, the IIP expanded in June-July after moderating in April and May. In terms Improved rural prospects from kharif sowing are of the use-based classification, all sectors except for mirrored in high frequency indicators, viz., sales of consumer durables exceeded 2019-20 levels by July tractors and two-wheelers (Table III.8). Exports of (Chart III.20). Manufacturing activity dipped in May agriculture and allied products also expanded. Chart III.19: Weighted Contribution to Industrial GVA Growth Table III.8: Rural Economy - High Frequency Indicators Items Unit April- April- April- Aug Aug Aug 2019 2020 2021 Tractor sales Number (in lakh) 2.7 2.9 3.5 Two-wheeler sales Number (in lakh) 80.4 41.3 49.9 Fertiliser sales Lakh tonnes 212.2 253.6 221.7 Demand for employment Crore households 10.4 15.2 14.7 (MGNREGA) Agriculture and allied sector USD billion 11.8 11.3 15.4 exports* Agriculture credit growth* y-o-y 7.3 4.8 11.3 Rice stock to buffer norm* Ratio 2.2 2.6 2.9 Wheat stock to buffer norm* Ratio 1.5 1.9 1.9 Sources: Tractor Manufactures Association; SIAM; Ministry of Chemicals and Fertilisers; Ministry of Rural Development; CMIE; RBI; and Food Corporation of India. Sources: NSO and RBI staff estimates. *: As at end-August. 50Chapter III Demand and Output Chart III.20: Index of Industrial Production (IIP) a: Sectoral Contribution to IIP Growth (y-o-y) b: Sectoral Contribution to IIP Growth over 2019 c: Use-based Contribution to IIP Growth (y-o-y) d: Use-based Contribution to IIP Growth over 2019 Sources: NSO; and RBI staff estimates. but gained momentum in June-July. The production Chart III.21: PLI Scheme: Sectoral of motor vehicles, trailers, machinery equipment, Financial Outlays electrical equipment, textiles and beverages supported IIP growth in July. Manufacturing activity is expected to be boosted by the PLI scheme for 13 sectors, aimed at creating global manufacturing champions for an AtmaNirbhar Bharat, with an outlay of about Rs. 1.97 lakh crore over 5 years. The PLI scheme, implemented across ten sectors so far (Chart III.21), can improve the manufacturing sector’s global competitiveness and participation in the global supply chain, giving impetus to domestic production, exports, investment in cutting edge technology, innovations and employment opportunities by establishing linkages with the MSME sector. Source: PIB. 51Monetary Policy Report October 2021 Chart III.22: Electricity Generation and Consumption a: Electricity Generation and Demand Growth b: Electricty Consumption: Region-wise Sources: Central Electricity Authority and Power System Operation Corporation Limited (POSOCO). Electricity generation improved substantially in According to the Reserve Bank’s industrial outlook Q1:2021-22 on a y-o-y basis but remained below 2019- survey, the manufacturing sector’s sentiments 20 levels. Thermal and renewable sources expanded rebounded in Q2:2020-21, with the business y-o-y by 24.1 per cent and 12.9 per cent, respectively, assessment index improving to 116.7 in Q2:2021-22 with the latter surpassing 2019-20 levels. In Q2, the from 89.7 in Q1:2021-22. For Q3:2021-22, respondents electricity generation expanded by 1.6 per cent and expect further improvement in production volumes, 15.8 per cent, respectively, in July and August, with new orders and job landscape. The manufacturing hydro and thermal power generation also exceeding pre-pandemic levels (Chart III.22a). Electricity Chart III.23: Manufacturing Sector's Profitability consumption rose across the country in July and August, with base effects leading to faster growth in some regions (Chart III.22b). Competition and efficiency in electricity distribution should accrue from the Electricity Amendment Bill 2021 which aims to delicense electricity distribution and allow entry of private players. The buoyant y-o-y expansion in nominal GVA of manufacturing in Q1 was supported by strong corporate profitability (Chart III.23). Apart from the base effect, the substantial contraction in interest expenses on the back of easy financial conditions contributed to Note: Data for Q1:2021-22 are based on results of 1,647 listed private the surge in profitability, even as employee costs and manufacturing companies. Source: RBI staff estimates based on data published by listed companies. operating expenses posted an uptick. 52Chapter III Demand and Output Chart III.24: PMI Manufacturing and Services a: PMI Manufacturing b: PMI Services Note: >50: Expansion, < 50: Contraction. Source: IHS Markit. purchasing managers’ index (PMI) remained in Overall, the manufacturing activity is gradually expansion zone at 53.7 in September, driven by normalising with the waning of the second wave strengthening demand conditions (Chart III.24a). (Table III.9). Consumer non-durables, surpassed the Table III.9: Industrial Sector: Progress towards Normalisation (Ratio to the respective month/quarter of 2019-2020) Indicators 2020-21 2021-22 Q1 Q2 Q3 Q4 Q1 Apr May Jun Jul Aug Sep I Industrial Production PMI: Manufacturing (>50 indicates growth over previous month) 35.1 51.6 57.2 56.9 51.5 55.5 50.8 48.1 55.3 52.3 53.7 II Index of Industrial Production 64 94 102 106 93 100 86 95 100 Manufacturing 60 94 102 107 92 99 83 94 98 Capital goods 35 87 99 109 74 82 61 79 100 Infrastructure & construction goods 53 98 105 110 98 107 89 98 102 Consumer durables goods 32 90 107 118 73 81 57 83 92 Consumer non-durables goods 83 100 103 105 98 100 92 102 100 III Eight Core Industries Index 76 95 100 104 96 101 92 96 102 104 Steel 51 100 103 113 97 102 92 96 102 106 Cement 62 89 96 110 97 104 88 100 105 117 Electricity demand 84 99 106 108 98 107 91 97 106 115 105 III Production of Automobiles Passenger vehicles 16 93 116 117 83 96 43 116 112 99 Two wheelers 21 95 118 129 60 81 31 70 84 89 Three wheelers 23 45 66 84 61 69 51 62 66 57 Production of tractors 60 123 162 167 133 128 105 171 149 151 Sources: CMIE; CEIC; NSO; SIAM; and RBI staff estimates. (cid:197) Below pre-Covid level Normalisation / recovery of activity (cid:198) 53Monetary Policy Report October 2021 pre-COVID levels during June and remained strong in while finished steel consumption moderated in Q2, while infrastructure and primary goods, steel, and August (Chart III.25). cement made progress towards normalisation in June Transportation services remained relatively upbeat and surpassed pre-pandemic level in Q2. during Q1 and gained further in Q2 with the gradual III.2.3 Services unwinding of the regional lockdowns. Railway freight traffic remains above pre-COVID levels and posted The second wave impacted the services sector in a a robust growth of 16.9 per cent in August, while disproportionately high manner in view of the blow port cargo traffic reached its pre-pandemic level in to contact-intensive services. Services contracted by August. Toll collections in Q1 and Q2 have stayed above double digits sequentially in Q1:2021-22, interrupting the pre-pandemic levels due to a greater use of FASTag the recovery from the first wave. On a y-o-y basis, (Table III.9). Commercial vehicle sales – an indicator of however, the services sector expanded by 16.1 per cent transportation services – almost halved sequentially in Q1:2021-22 driven by a favourable base effect. With in Q1, but there are reports of an uptick in sales in the retreating of the second wave, services regained Q2. The aviation sector displayed segmentation, with momentum in Q2 as shown by high frequency passenger traffic lagging cargo traffic considerably. indicators, and contact-intensive services began Domestic air passenger traffic is, however, gaining mending with the gradual easing of restrictions and traction with the lifting of the restrictions and the accelerated pace of vaccination (Table III.9). GST increasing confidence. The communication services collections and issuances of e-way bills – indicators performed well in Q1 and Q2, driven by pandemic- of wholesale and retail trade – revived to pre- induced digitisation of the economy. pandemic levels from June/July onwards, suggesting Despite the strong performance of information strengthening domestic trading activity. Some revival technology and financial companies, GVA in financial, in discretionary spending and pent-up demand are real estate and professional services posted a also boosting trading activity and e-commerce. In the subdued growth of 3.7 per cent in Q1 and moderated construction sector, cement production rose further substantially over the preceding quarter as businesses Chart III.25: Services Sector a: Service Sector Components b: Construction Indicators Sources: Office of Economic Adviser, Joint Plant Committee, Department of Industrial Policy & Promotion, Ministry of Commerce & Industry. 54Chapter III Demand and Output Table III.10: Services Sector: Progress towards Normalisation (Ratio to the respective month/quarter of 2019-2020) Indicators 2020-21 2021-22 Q1 Q2 Q3 Q4 Q1 Apr May Jun Jul Aug Sep PMI: Services (>50 indicates growth over previous month) 17.2 41.9 53.4 54.2 47.2 54 46.4 41.2 45.4 56.7 55.2 I Construction Steel consumption 49 93 114 121 98 111 89 95 94 85 Cement production 62 89 96 110 97 104 88 100 105 117 II Trade, hotels, transport, communication and services related to broadcasting Commercial vehicle sales (Quarterly average) 15 80 99 143 51 Domestic air passenger traffic 7 25 50 72 31 52 17 26 42 56 Domestic air cargo 26 68 90 105 78 95 66 74 83 87 International air cargo 43 77 87 101 94 96 91 95 92 94 Freight traffic 79 105 111 113 110 110 109 111 113 122 121 Port cargo 80 91 102 108 102 102 102 102 93 100 99 Toll collection: volume 184 349 295 174 548 633 423 593 704 719 675 Petroleum consumption 74 89 99 102 88 93 79 92 95 93 GST E-way bill 50 100 115 128 97 112 74 106 118 120 128 GST revenue 59 92 108 114 107 124 102 93 114 114 127 III Financial, real estate and professional services Credit outstanding y-o-y growth (per cent) 5.6 5.1 6.2 5.6 5.9 6.2 5.9 6.1 6.1 6.7 6.7 Bank deposits y-o-y growth (per cent) 9.6 10.5 10.8 11.4 9.9 11.2 9.5 9.8 9.8 9.5 9.3 Life insurance: first year premium 81 116 97 135 87 98 70 93 95 118 Non-life insurance premium 95 106 105 114 108 109 101 114 140 137 Sources: CMIE; CEIC; NSO; MOSPI; IRDAI; RBI staff estimates. (cid:197) Below pre-Covid level Normalisation / recovery of activity (cid:198) in other segments faltered due to mobility related Public administration, defence and other services restrictions. Some recovery, however, was seen in (PADO) expanded moderately in Q1:2021-22 on a y-o-y the travel and hospitality industries, real estate and basis. The central government’s revenue expenditure, other contact-intensive professional services in Q2. excluding interest payments and subsidies, contracted Growth in aggregate deposits remained buoyant and in Q1 on an unfavourable base while that of state bank credit recorded some improvement, extending governments posted a double-digit growth. Other support to financial services during Q2. Real estate services in PADO – private education; heath; personal activity dampened in Q1 as new launches and sales services; and cultural and recreational activities – were hampered by the lockdowns. The inventory remained tepid. overhang stagnated at an average of 58 months in Q1 In August and September, the PMI services re-entered (Chart III.26a). All-India housing prices, according to the expansion zone reversing the second wave the RBI’s index, showed a deceleration in Q1:2021- induced contraction of May-July (Chart III.24b). The 22, dragged down by Bengaluru, Chennai and Delhi PMI composite output index rose to 55.3 in September (Chart III.26b). from 49.2 in July. 55Monetary Policy Report October 2021 Chart III.26: Housing Sector – Launches, Sales and Prices a: Housing Activity b: Housing Price Index of RBI Sources: PropTiger and RBI. III. Conclusion minimum support prices for the ensuing rabi season. The recovery in manufacturing and services activities, The momentum of economic activity was interrupted during Q1:2021-22 by the second wave. Aggregate including contact-intensive services, in H2 should get demand began reviving in June and gained momentum a fillip from the growing proportion of the inoculated in Q2. It is expected to strengthen further in H2 with population, further normalisation of supply chains, the recovery in both urban and rural consumption. congenial financing conditions and the government’s On the supply side, agriculture and allied activities infrastructure and asset monetisation push. The should benefit from the good kharif sowing and outlook, however, remains critically dependent upon harvest. Rabi sowing and total crops production are expected to be well-supported by improving water the evolution of COVID-19’s trajectory and the progress storage in reservoirs and the early announcement of of vaccination to cover the rest of the population. 56Chapter IV Financial Markets and Liquidity Conditions IV. Financial Markets and Liquidity Conditions During H1:2021-22, domestic financial markets remained vibrant amidst easy liquidity conditions, notwithstanding the ravages unleashed by the virulent second wave of the pandemic in April-May 2021. Monetary transmission improved further, due to abundant liquidity and forward guidance by the MPC of continuing with the accommodative stance. Going forward, liquidity conditions would continue to be accommodative in consonance with the monetary policy stance through calibrated liquidity management operations. Global financial markets remained exuberant financial markets. Concerns about a possible third through most of H1:2021-22, buoyed by a surfeit of wave, uncertainty over the path of the US Fed’s liquidity, ultra-accommodative monetary policies tapering of asset purchases, elevated inflation, and in major advanced economies (AEs) and forward the large government borrowing programme kept guidance promising continuation of these policies. market sentiments edgy. Investor optimism has caused valuations across a IV.1.1 Money Market range of assets to be elevated. Stock markets scaled Money market rates consistently traded below the peaks repeatedly in most AEs and select emerging reverse repo rate – the lower bound of the liquidity market economies (EMEs), with intermittent bouts adjustment facility (LAF) corridor – during H1:2021- of corrections sparked by the rapid spread of the 22 (Chart IV.1). The weighted average call rate (WACR) Delta variant of COVID-19. Bond yields softened in – the operating target of monetary policy – traded AEs as markets increasingly acquiesced with central 17 basis points (bps) below the floor of the corridor banks that inflationary pressures are transient and on an average during H1. With the Reserve Bank would not trigger normalisation. In EMEs, bond yields becoming the major counterparty for banks, there was experienced two-way movements, with phases of hardening in response to the uncertainty over the Chart IV.1: Liquidity, Policy Corridor and WACR timing and pace of tapering of asset purchases by the US Federal Reserve. In currency markets, the US dollar strengthened from May 2021 on better economic prospects and consequently, some EME currencies depreciated while others faced appreciation pressures because of carry trade and search for returns. IV.1 Domestic Financial Markets During H1:2021-22, domestic financial markets remained vibrant amidst easy liquidity conditions, notwithstanding the ravages unleashed by the virulent second wave of the pandemic in April-May 2021. Large liquidity injections, including through the secondary market acquisition programme of government Source: Reserve Bank of India (RBI). securities (G-SAP), ensured orderly conditions in 57Monetary Policy Report October 2021 a shrinkage in inter-bank trading activity – average total overnight money market volume – from 6.0 per daily volume in the call money market declined to cent in February 2020 (pre-pandemic) to 2.0 per cent `7,381 crore in September 2021 from `10,126 crore in in September 2021. In the collateralised segment, the March 2021. share of triparty repo in total overnight money market volume increased to 74 per cent in September 2021 In the overnight call money segment, the weighted from 72 per cent in March 2021 while the share of average rate (WAR) of traded deals generally remained market repo declined to 24 per cent from 26 per cent above the reverse repo rate while that on reported during the same period (Chart IV.3). Mutual funds, deals1 remained below the reverse repo rate, reflecting the major lenders in both the collateralised segments, market segmentation as small co-operative banks – increased their participation further in H1 from 68 per principal lenders in reported deals – do not have the cent to 70 per cent in the triparty repo segment and requisite information technology (IT) infrastructure from 61 per cent to 63 per cent in market repos. On to access the Negotiated Dealing System - Call (NDS- the borrowing side, there was an increase in the share Call) and usually lend bilaterally towards the close of of private banks in both the secured segments – from market hours at lower rates. The share of the reported 24 per cent in March 2021 to 25 per cent in September deals in total volumes in the call money segment 2021 for triparty repo and from 13 per cent to 14 per increased to 60 per cent in H1:2021-22 from 54 per cent for market repo. cent in H2:2020-21 (Chart IV.2), driven by a rise in lending by co-operative banks from 65 per cent of the The rates in the secured overnight segments remained total volume of the call money segment to 80 per cent consistently below the reverse repo rate during over the same period. H1:2021-22 on surplus liquidity (Chart IV.4). Interest rates on longer-term money market instruments like The surplus liquidity conditions also led to a 91-day Treasury Bills (T-bills) and 3-month certificates diminishing share of the uncollateralised segment in of deposit (CDs) traded marginally above the reverse Chart IV.2: Share of Traded/Reported repo rate, on average, by 1 bp and 8 bps, respectively Deals in Call Money Market Chart IV.3: Share in Overnight Money Market Volumes Sources: Clearing Corporation of India Ltd. (CCIL); and RBI. 1 ‘Traded deals’ are negotiated directly on the NDS-Call platform whereas ‘reported deals’ are over-the-counter (OTC) deals which are reported on Source: RBI. the NDS-Call platform after the completion of negotiation of deals. 58Chapter IV Financial Markets and Liquidity Conditions crore during the corresponding period of 2020-21 Chart IV.4: Money Market Rates (Chart IV.5a). CP rates generally traded above the reverse repo rate, with an average spread of 46 bps during H1:2021-22. The weighted average discount rate (WADR) firmed up in July 2021 due to increased issuances by non-banking financial companies (NBFCs), partly to mobilise resources for investment in initial public offerings (IPOs), but moderated subsequently. The share of NBFCs in total CP issuances increased to 43.2 per cent in H1: 2021-22 from 21.9 per cent in the corresponding period of the previous year while that of corporates moderated to 46.2 per cent from 64.9 per cent over the same period (Chart IV.5b). IV.1.2 Government Securities (G-sec) Market Sources: RBI; CCIL-F-TRAC; Financial Benchmarks India Private Ltd. (FBIL); and During H1:2021-22, the 10-year G-sec yield softened RBI staff estimates. by 11 bps, aided by a host of measures taken by the during H1:2021-22. Issuance of CDs increased to Reserve Bank to foster an orderly evolution of the `56,658 crore during H1:2021-22 from `45,165 crore yield curve. During April-May 2021, the 10-year G-sec in the corresponding period of 2020-21, reflecting yield softened by 6 bps on (i) the monetary policy congenial financing conditions. committee (MPC) continuing with its accommodative Riding on the surplus liquidity conditions, commercial growth-supportive stances; (ii) the announcement paper (CP) issuances increased substantially to of G-SAP 1.0 of `1 lakh crore for Q1; and (iii) special `10.1 lakh crore during H1:2021-22 from `7.9 lakh OMOs (operation twist) of `10,000 crore, although Chart IV.5: Primary Issuances of Commercial Paper a: Systemic Liquidity, Issuances and WADR b: Institutional Break-up Sources: RBI; CCIL-F-TRAC; and RBI staff estimates. 59Monetary Policy Report October 2021 fears of additional government borrowing to bridge the The dynamics of movements in the yield curve can GST compensation cess shortfall imparted transient be captured by its level and slope2 (Chart IV.7a). While bearishness to market sentiment. Yields hardened in the average level of yields softened by 3 bps, the slope June by 8 bps over elevated May inflation print and steepened by 28 bps during H1. Short term yields higher crude oil prices. Overall, however, the 10-year remained anchored around the policy rate while long yield remained range bound during Q1:2021-22. term yields reflected inflation concerns and the size of In Q2, the 10-year yield initially declined to 6.13 per the government borrowing programme (Chart IV.7b). cent on July 15, 2021 aided by a lower than expected At the shorter end of the secondary market, yields on CPI inflation print for June and issuance of a new treasury bills (T-bills) softened and traded below the 10-year benchmark security at a coupon of 6.10 per reverse repo rate for some maturities (Chart IV.8). In cent (Chart IV.6). In August, however, yields hardened terms of the traded volume, 91-day T-bills remained by 5 bps in reaction to the MPC’s inflation forecast the dominant segment in the secondary market with being revised upwards above expectations and fears a share of about 41 per cent. of liquidity tightening on the announcement of a In order to facilitate debt consolidation, the Reserve calendar for an enhanced scale of variable rate reverse Bank conducted six switch operations on behalf of repo (VRRR) auctions. In the first half of September, yields softened as these apprehensions were allayed, the central government amounting to `31,907 crore along with (i) the resumption of portfolio debt during H1:2021-22. The weighted average maturity inflows; (ii), lower than expected fiscal deficit of the (WAM) of the outstanding stock of G-secs increased to central government for April-July; and (iii) a softer CPI 11.57 years at end-September 2021 from 11.31 years at inflation print. Yields, however, firmed up during the end-March 2021. The weighted average coupon (WAC) second half of the month tracking US treasury yields moderated to 7.15 per cent from 7.27 per cent over the and hardening crude oil prices. same period. Chart IV.6: 10-year Yield, Repo Rate and Liquidity Conditions Softer than expected CPI print, issuance of new paper G-SAP announcement Rise in CPI Illiquidity on previous papers Rise in US treasury yields and crude oil prices Sources: RBI, and FBIL. 2 The level is the average of par yields of all tenors up to 30-years published by FBIL and the slope (term spread) is the difference in par yields of 3-months and 30-year maturities. 60Chapter IV Financial Markets and Liquidity Conditions Chart IV.7: G-Sec Yield Curve a: Shifts b: Changes in Level and Slope Source: FBIL and RBI staff estimates State Development Loans IV.1.3 Corporate Bond Market The weighted average spread of cut-off yields on Corporate bond yields softened during H1:2021-22 state development loans (SDLs) over G-sec yields while risk premia (over G-sec yields of comparable of comparable maturities declined to 48 bps in maturities) exhibited a mixed trend amidst moderation H1:2021-22 from 53 bps in H1:2020-21 (Chart IV.9). in new issuances. The monthly average yield on AAA- The average inter-state spread on securities of 10-year rated 3-year bonds issued by NBFCs declined by 37 bps tenor (fresh issuances) was 4 bps in H1:2021-22 as to 5.32 per cent, while those on corporates and public- compared with 9 bps in H1:2020-21. sector undertakings (PSUs), financial institutions (FIs) Chart IV.9: SDLs - Amount Raised and Spread Chart IV.8: FBIL -T-Bill Benchmark (Yield to Maturity) Source: FBIL. Sources: RBI and Staff estimates. 61Monetary Policy Report October 2021 Chart IV.10: Corporate Bond Yields and Spread on AAA-rated 3-year bonds a: Yields b: Spreads Source: Fixed Income Money Market and Derivatives Association of India (FIMMDA). and banks moderated by 32 bps to 5.24 per cent and Issuances of corporate bonds in the primary market by 48 bps to 5.33 per cent, respectively (Chart IV.10a). declined to `1.81 lakh crore during H1:2021-22 During the same period, the monthly average risk (up to August 2021) from `3.17 lakh crore during premium or spread on AAA-rated 3-year bonds (over the corresponding period of the previous year 3-year G-sec yields) increased marginally from 48 bps (Chart IV.11a). Resource mobilisation in the corporate to 49 bps for NBFCs and from 35 bps to 40 bps for bond market was overwhelmingly through the private corporates while moderating from 60 bps to 50 bps for placement route (97.0 per cent). PSUs, FIs and banks (Chart IV.10b). Outstanding investments by foreign portfolio Corporate bond yields eased across tenors and ratings investors (FPIs) in corporate bonds declined marginally spectrum. For the lowest rated investment grade from `1.33 lakh crore at end-March 2021 to `1.28 lakh corporate bonds (BBB-), yields declined by 18 bps crore at end-September 2021. Consequently, their (Table IV.1). The market perception of credit risk also utilisation of the approved limits declined from 24.5 improved, with the 3-year credit default swap (CDS) per cent to 22.3 per cent. The daily average secondary spreads for the State Bank of India and the ICICI Bank market trading volume declined by 26.0 per cent to moderating by 2 bps and 3 bps, respectively, during H1. `7,056 crore during H1 (up to August 2021) over the Table IV.1: Financial Markets - Rates and Spread Instrument Interest Rates (per cent) Spread (bps) (over corresponding risk-free rate) Mar 2021 Sep 2021 Variation (in bps) Mar 2021 Sep 2021 Variation (in bps) 1 2 3 (4 = 3-2) 5 6 (7 = 6-5) Corporate Bonds (i) AAA (1-yr) 4.30 4.17 -13 32 35 3 (ii) AAA (3-yr) 5.56 5.24 -32 35 40 5 (iii) AAA (5-yr) 6.27 5.88 -39 17 4 -13 (iv) AA (3-yr) 6.31 6.07 -24 110 124 14 (v) BBB-minus (3-yr) 10.17 9.99 -18 496 516 20 10-yr G-sec 6.19 6.18 -1 Note: Yields and spreads are computed as monthly averages. Source: FIMMDA and Bloomberg. 62Chapter IV Financial Markets and Liquidity Conditions Chart IV.11: Corporate Bond Market Activity a: Primary Market Issuances b: Secondary Market Turnover - Daily Average Source: SEBI. corresponding period of the previous year, in sync activity post the second wave, strong corporate with the reduction in new issuances (Chart IV.11b). earnings, and pick-up in the vaccination drive. The BSE Sensex gained 19.4 per cent in H1 to close at Most of the debt issuances in H1:2021-22 were 59,126 on September 30, 2021 (Chart IV.13a). Indian undertaken by firms in financial services, banking/ equities emerged as the best performing amongst term lending, and the housing finance sector peers on a year to date (YTD) basis (Chart IV.13b) with (Chart IV.12). their share in world market capitalisation increasing IV.1.4 Equity Market to 2.93 per cent on September 30, 2021 from the long- The Indian equity market scaled new highs in H1:2021- term average of 2.43 per cent (Chart IV.13c). During 22, lifted by the gradual normalisation of economic H1:2021-22, FPIs were net buyers to the tune of ` 8,326 crore while net purchases of domestic institutional Chart IV.12: Industry-wise Debt Issuances investors (DIIs) amounted to `47,763 crore (Chart IV.13d). The bull run rode on higher domestic participation, buoyed by the increasing interest of retail investors. Direct retail holdings in NSE listed stocks rose to 7.2 per cent of market capitalisation in June 2021 from 6.4 per cent in December 2019 (Chart IV.14a). The number of dematerialised (Demat) accounts with the country’s two main depositories has gone up from 5.5 crore at end-March 2021 to 6.49 crore at end-July 2021. Furthermore, indirect retail participation through monthly systematic investment plans (SIPs) reached a new high of `9,923 crore in August – 8.1 per cent above March 2021. The number of retail SIP accounts surged Source: Prime Database. to 4.3 crore with 24.9 lakh new accounts registered 63Monetary Policy Report October 2021 Chart IV.13: Stock Market Indices and Institutional Investments a: BSE Sensex and Dow Jones Industrial Average b: Major EM and AE Indices: Sep 21 over March 21 c: India's Share in World Market Capitalisation d: Net Investment in Equity by Institutional Investors Note: *Long term average computed for last 10 years. Sources: Bloomberg; NSDL; Capitaline and SEBI. in August – the highest-ever monthly registration The exuberance in the equity market was also (Chart IV.14b). reflected in the IPO segment. During H1:2021-22, Chart IV.14: Retail Participation in Equity Market a. Direct Retail Holdings in Stocks b. Mutual Fund SIP Accounts and their Contribution Sources: Prime Database and Association of Mutual Funds in India (AMFI). 64Chapter IV Financial Markets and Liquidity Conditions Chart IV.15: Initial Public Offer and Equity Risk Premium a: Initial Public Offers (Equity) b: Equity Risk Premium for India Note: Data exclude IPOs raised on SME platforms. Sources: SEBI, Bloomberg and RBI staff estimates. 22 IPOs were listed, mobilising `46,316 crore as By May 28, the INR appreciated to `72.48. In June, it against `1,798 crore in the corresponding period last traded with a depreciation bias, despite robust FPI year (Chart IV.15a). The amounts raised through rights equity inflows, as the US dollar gained traction. Since issues, however, fell sharply to `793 crore in H1from then, the INR has moved in both directions driven by `59,983 crore during the corresponding period of the FPI flows, crude oil prices and incoming information previous year. The total mobilisation through public on monetary policy normalisation plans of major and rights issues reduced to `50,529 crore from advanced economies. `76,830 crore over the same period. The equity risk premium (ERP)3 – the difference Chart IV.16: Movements of Indian Rupee and between returns on equity and the risk-free rate – US Dollar Index eased through H1:2021-22 with the gradual recovery in market sentiments and moderated from 6.3 per cent at the height of the pandemic (end-March 2020) to 3.2 per cent by end-September 2021, moving below the pre-pandemic level (Chart IV.15b). IV.1.5. Foreign Exchange Market The Indian rupee (INR) exhibited two-way movements in H1:2021-22. It traded with a depreciating bias in April 2021 and touched `75.17 per US dollar on April 15 amidst FPI outflows and an appreciation of the US dollar (Chart IV.16). The depreciating bias quickly reversed as FPI flows rebounded with a sharp fall in Sources: FBIL; and Thomson Reuters. domestic COVID-19 cases and a weakening US dollar. 3 Sachdeva, P. and A. Borad (2020), “Demystifying Equity Prices using Dividend Discount Model: An Indian Context”, Reserve Bank of India Bulletin, October. 65Monetary Policy Report October 2021 Chart IV.17: Cross-Currency Movements a: Movement of Major EME Currencies against US Dollar b: Movement in REER (end-September 2021 over end-March 2021) (August 2021 over March 2021) Sources: RBI; FBIL; IMF; Thomson Reuters; and Bank for International Settlements (BIS). The depreciation of the INR in nominal terms (against per cent (at end-September 2021 over the average the US dollar) as well as the appreciation of the real of March 2021), while it appreciated by 1.3 per cent effective exchange rate (REER) in H1 was modest in terms of the 40-currency REER (Table IV.2). The relative to EME peers (Chart IV.17). divergence between the two indices essentially reflects India’s higher inflation vis-à-vis its major In terms of the 40-currency nominal effective trading partners. exchange rate (NEER), the INR depreciated by 0.9 IV.1.6 Credit Market Table IV.2: Nominal and Real Effective Exchange During H1, credit offtake improved, with non-food Rate Indices (Trade-weighted) credit growth (y-o-y) increasing to 6.8 per cent on (Base: 2015-16 = 100) September 24, 2021 from 5.1 per cent a year ago Item Index: end-September Appreciation (+) / 2021 (P) Depreciation (-) (Per cent) (Chart IV.18). end-September 2021 over March (average) 2021 Credit growth among public sector banks remained 40-currency REER 105.3 1.3 modest, while there has been some uptick in the case 40-currency NEER 94.2 -0.9 6-currency REER 103.2 1.5 of the private sector banks (Chart IV.19a), which have 6-currency NEER 87.6 -1.1 provided the bulk (56.7 per cent) of the incremental `/US$ 74.26 -2.0 credit extended by scheduled commercial banks P: Provisional. Sources: RBI; and FBIL. (SCBs) on a y-o-y basis (as on September 24, 2021). 66Chapter IV Financial Markets and Liquidity Conditions (y-o-y) in August 2021 on the back of a favourable Chart IV.18: Non-food Credit Growth of SCBs monsoon and measures to support the farm sector (Chart IV.20a). Industrial credit growth remained subdued, mainly due to a decline in credit to large industries (which account for more than 80 per cent of credit extended to the sector). Credit to medium, and micro and small industries improved, benefitting from the government’s support measures for the MSME sector and the enhancement of the emergency credit line guarantee scheme (ECLGS) to support COVID-19 affected sectors. Services sector credit growth decelerated, dampened by the second wave of the pandemic. In terms of the contribution of different sectors in incremental credit (y-o-y basis), personal loans accounted for the largest share (52.5 Source: RBI. per cent) followed by the agriculture sector (22.2 per cent) (Chart IV.20b). The overall non-food credit They were followed by public sector banks (33.3 per growth in H1:2021-22 remains primarily driven by cent) and foreign banks (10.0 per cent) (Chart IV.19b). personal loans and credit to the agriculture sector (Chart IV.20c). Among the major sectors4, credit to agriculture continued to register double-digit growth since Within industry, credit to textiles, and chemicals and April 2021 and accelerated to 11.3 per cent chemical products registered accelerated growth in Chart IV.19: Credit Flow across Bank-Groups a: Growth b: Share Source: RBI. 4 Data on sectoral credit relate to select banks accounting for around 90 per cent of the total non-food credit. 67Monetary Policy Report October 2021 Chart IV.20: Sectoral Deployment of Bank Credit a: Growth (y-o-y) b: Share in Incremental Non-food Credit (y-o-y) c: Non-food Credit Growth: Contribution of Major Sub-sectors (y-o-y) Source: RBI. H1:2021-22 (up to August). Credit to infrastructure – have been raising resources mainly from money and which accounts for around 38 per cent of industrial debt markets. Credit growth to transport operators, credit – also showed improvement, led by credit to however, recovered in August 2021 after slipping into roads and airports. Credit growth to food processing, negative territory in April 2021 (Chart IV.21c). Credit to the trade sector contributed 1.5 percentage points beverage and tobacco lost momentum, while to the overall credit growth of the services sector in credit to basic metal and metal products contracted August 2021 (Chart IV.21d). Credit growth to personal (Chart IV.21a). The prime drivers of overall credit loan segment accelerated to 12.1 per cent in August growth to industry were infrastructure and textiles 2021 from 8.5 per cent a year ago, supported by special (Chart IV.21b). schemes of banks to support households during the Credit growth to the services sector decelerated to pandemic. Credit to housing, the largest constituent of 3.5 per cent in August 2021 from 10.9 per cent a year the personal loan segment, showed signs of recovery ago, largely due to slowdown in credit to NBFCs that in H1: 2021-22 (up to August 2021). 68Chapter IV Financial Markets and Liquidity Conditions Chart IV.21: Credit Growth in Select Sub-sectors Industry a: Growth (y-o-y) b: Contribution of Major Industries Services c: Growth (y-o-y) d: Contribution of Major Sub-components *Other industries include industries such as ‘mining and quarrying’, ‘leather and leather products’, ‘wood and wood products’, ‘paper and paper products’, ‘petroleum, coal products and nuclear fuels’, ‘rubber, plastic and their products’, ‘glass and glassware’, ‘cement and cement products’, ‘all engineering’, ‘vehicles, vehicle parts and transport equipment’, ‘gems and jewellery’, ‘construction’ etc. **Other services include services such as professional services, computer software, tourism, hotels and restaurants, shipping, aviation, mutual fund (MFs), banking and finance other than NBFCs and MFs. Source: RBI. The asset quality of SCBs improved during 2021-22 Banks’ non-SLR investments – covering instruments (up to June), with the overall non-performing assets like CPs, bonds, debentures and shares of public and (NPA) ratio declining to 7.5 per cent in June 2021 from private corporates – were lower during H1:2021-22 8.0 per cent a year ago (Chart IV.22a). The NPA ratio in than a year ago mainly due to lower investment in respect of retail loans and services increased over the bonds/shares and debentures (Chart IV.23a). Adjusted same period (Chart IV.22b). non-food credit5 growth increased from 5.1 per cent 5 Sum of non-food credit extended by SCBs and their investments in commercial paper, bonds/shares/debentures issued by private and public corporate sector. 69Monetary Policy Report October 2021 Chart IV.22: Stressed Assets and Non-Performing Assets of SCBs a: Overall Loan Portfolio of SCBs b: Sectoral Non-Performing Assets Source: RBI. in Q2:2020-21 to 6.2 per cent in Q2:2021-22 (Chart (LCR) requirements and collateral buffers for availing IV.23b). the liquidity adjustment facility (LAF) of the RBI With credit offtake remaining muted relative to deposit (Chart IV.24). growth, banks augmented their statutory liquidity IV.2 Monetary Policy Transmission ratio (SLR) portfolios. Excess SLR investments rose Monetary transmission to deposit and lending to 12.5 per cent of net demand and time liabilities (NDTL) on September 10, 2021 from 11.0 per cent rates of banks improved further in H1:2021-22. The of NDTL at end-March 2021. This provides banks abundance of systemic liquidity, forward guidance the cushion to meet their liquidity coverage ratio by the MPC of continuing with the accommodative Chart IV.23: Non-SLR Investment and Adjusted Non-Food Credit a: Non-SLR Investment b: Adjusted Non-food Credit Source: RBI. 70Chapter IV Financial Markets and Liquidity Conditions Chart IV.24: Excess SLR of Banks Table IV.3: Transmission from the Repo Rate to Banks’ Deposit and Lending Rates (Variation in basis points) Period Repo Term Deposit Lending Rates Rate Rates Median WADTDR 1 - Year WALR WALR TDR (Out- Median (Out- (Fresh (Fresh standing MCLR standing Rupee Deposits) Deposits) Rupee Loans) Loans) February 2019 - -110 -9 -7 -30 2 -43 September 2019 (Pre-External Benchmark Period) October 2019 -140 -187 -174 -125 -120 -147 – September 2021 (External Benchmark Period) *Up to September 10, 2021 March 2020 - -115 -154 -135 -103 -102 -121 Source: RBI. September 2021 (COVID period) stance, subdued credit demand and the introduction February 2019 – -250 -213 -181 -155 -118 -190 September 2021 of the external benchmark regime for select sectors (Current Easing in October 2019 aided monetary transmission. There Cycle) has been a complete pass-through of the policy repo Memo rate cuts to the weighted average lending rate (WALR) April 2021 – 0 0 -18 -5 -12 1 September 2021 on fresh rupee loans since October 2019 (Table IV.3). Note: Latest data on WALRs and WADTDR pertain to August 2021. The transmission of policy repo rate cuts to the WALR: Weighted average lending rate; WADTDR: Weighted average domestic term deposit rate; WALR on outstanding loans has also been sizeable at MCLR: Marginal cost of funds-based lending rate; TDR: Term deposit rate. 120 bps in the external benchmark period (Box IV.1). Source: RBI. Box IV.1: External Benchmark Regime and Transmission to Lending Rates While the Reserve Bank has periodically refined the benchmarks effective October 1, 2019 and for medium process of interest rate setting by banks, transmission enterprises effective April 1, 2020). has hitherto been sluggish as banks relied on own cost of Under this system, any change in the benchmark rate is funds, i.e., internal benchmarks. The systems were also mandated to be passed on to the lending rates for new characterised by opacity, especially regarding the interest and existing borrowers on a one-to-one basis and banks rate resetting practices for existing borrowers. To address are prohibited from adjusting their spreads for existing these rigidities, the Reserve Bank decided to move to an borrowers for a period of three years in the absence of external benchmark system – an interest rate outside the any significant credit event. Reflecting the regulatory control of a bank and not necessarily linked to its internal requirement, the share of external benchmark-linked costs – for select categories of loans (viz., all new floating loans in total outstanding floating rate loans increased rate personal or retail loans and floating rate loans to from 2.4 per cent in September 2019 to 32 per cent in June micro and small enterprises (MSEs) to the policy repo 2021, contributing to a faster and fuller transmission. rate or 3-month or 6-month T-bill rate or other specified (Contd.) 71Monetary Policy Report October 2021 Table IV.1.1: Outstanding Floating Rate Rupee Loans of SCBs across Interest Rate Benchmarks (Per cent to total) Bank group Base Rate MCLR External Benchmark Sep-19 Mar-20 Mar-21 Jun-21 Sep-19 Mar-20 Mar-21 Jun-21 Sep-19 Mar-20 Mar-21 Jun-21 Public sector banks 15.0 12.3 7.9 8.1 82.7 80.9 69.1 66.5 0.4 4.9 20.3 23.9 Private banks 8.3 6.8 3.9 3.6 86.7 74.9 52.6 49.6 4.6 17.3 42.7 46.1 Foreign banks 6.8 5.2 2.7 2.7 67.3 56.7 30.7 33.5 25.7 37.9 66.6 63.7 All SCBs 12.7 10.5 6.5 6.5 83.6 78.5 62.9 60.2 2.4 9.4 28.5 32.0 Note: Data pertain to 74 SCBs. Figures in table may not add up to hundred due to residual BPLR-linked loans. Source: RBI. There has been a concomitant fall in the share of MCLR- bps change in the repo rate results in 93 bps change in the linked loans from 83.6 per cent to 60.2 per cent, over the WALR on fresh loans over time (equation 1)6. same period, although these still have the largest share in WALR_f = -11.8 + 0.93 REPO + 0.21 CD Ratio ..…. (1) outstanding floating rate loans (Table IV.1.1). (0.18) (0.00) (0.07) As lending rates under the external benchmark regime t = -0.56 t-1 -0.34 t-2 + 0.30 t – 0.01 t + undergo automatic adjustments with the changes in the (0.0) (0.00) (0.01) (0.39) benchmark rate, banks are incentivised to adjust their 0.40 t)*(DUMEBLR) – 0.10 DUMDEMO + 0.19 DUMTAPR - 0.11 ECTt-1 …… (2) term as well as saving deposit rates to cushion their ne t (0.03) (0.10) (0.00) (0.00) interest margins and profitability, which then hastens the Notes: Figures in parentheses are p-values; Adjusted = 0.35; Breusch- adjustment in banks’ marginal cost of funds, and MCLRs Godfrey LM test for null of no serial correlation (6 lags) (p-value) = 0.88; (Chart IV.2.1). An error correction model (ECM) using the represents month-on-month change in the respective variables. autoregressive distributed lag (ARDL) framework (Pesaran The adjustment, however, takes time as indicated by et al., 2001) for the period January 2013 to June 2021 with the error correction coefficient of 0.11 (equation 2), the following variables – weighted average lending rate i.e., 11 per cent of the deviation from the equilibrium on fresh rupee loans (WALR_f ), repo rate (REPO) and relationship is corrected every month7. Thus, it takes six credit to deposit ratio (CD Ratio) – indicates that a 100 months for one-half of the long-run pass-through. The speed of adjustment can be expected to improve as the Chart IV.1.1: WALR and Credit to Deposit Ratio of SCBs proportion of external benchmark linked loans increases further. This is borne out by the statistical significance of the interaction between the changes in the repo rate and the dummy representing the external benchmark period ((cid:39)REPO*DUM ). t EBLR References: Pesaran, M.H, Shin, Y. and Smith, R.J. (2001), “Bounds Testing Approaches to the Analysis of Level Relationships”, Journal of Applied Econometrics, 16, 289-326. Reserve Bank of India (2017), “Report of the Internal Study Group to Review the Working of the Marginal Cost of Funds-based Lending Rate System”. 6 Unit root tests indicate that WALR_f, REPO and CD Ratio are I(1). Based on AIC criteria, ARDL(3,1,1) model is selected. Bounds test confirms cointegration at 1 per cent level of significance. 7 In equation 2, is dummy for the external benchmark period, i.e., October 2019 to June 2021; is dummy for taper tantrum period (July to September 2013); and is dummy for the demonetisation period (November 2016 to February 2017). 72Chapter IV Financial Markets and Liquidity Conditions Chart IV.25: Lending Rates of Scheduled Chart IV.26: Transmission across Bank-Groups Commercial Banks (February 2019 - August 2021) Source: RBI. Source: RBI. This has been facilitated by the sustained reduction sharpest in the case of education loans, followed by in the marginal cost of funds-based lending rate other personal loans and loans to large industries (MCLR) – the one-year median MCLR fell from 8.8 per (Chart IV.27). cent in January 2019 to 7.25 per cent in August 2021 Chart IV.27: Transmission to WALR - (Chart IV.25)8. Sector-wise (April 2020 - August 2021) Across bank groups, foreign banks exhibited maximum transmission to lending and deposit rates, reflecting a higher proportion of their liabilities being made up of low cost and lower duration wholesale deposits, which facilitates a faster repricing of interest rates (Chart IV.26). Among domestic banks, public sector banks (PSBs) and private sector banks (PvBs) exhibited a similar degree of pass-through to lending rates. The WALRs of PSBs, however, remain lower than those of PvBs9. The decline in WALRs on fresh rupee loans as well as *: ‘Other personal loans’ include personal loans other than housing, vehicle, outstanding rupee loans has been broad-based across education and credit card loans. WALR: Weighted average lending rate. sectors. For fresh loans, the decline in WALR was the Source: RBI. 8 With the policy rate cut cycle commencing in February 2019, more and more loans linked to MCLR (primarily in the 1-year bucket) are getting reset from February 2020. 9 The WALR on fresh rupee loans for public sector banks and private sector banks stood at 7.51 per cent and 8.83 per cent, respectively, in August 2021. 73Monetary Policy Report October 2021 Chart IV.28: Sector-wise WALR relative to 1-Year Chart IV.29: Transmission to WALR (Fresh Rupee Median MCLR (August 2021) Loans) - Personal Loans and Loans to MSMEs (October 2019 - August 2021) Source: RBI. Source: RBI. Spreads of WALRs on fresh rupee loans (relative to There has been a moderation in deposit rates across 1-year MCLR) are the lowest in the large industry tenors (Chart IV.30a). The median term deposit rate segment. Among retail loans, the spread charged on fresh deposits – based on average card rates on by domestic banks was the lowest in respect of fresh deposits across all tenors – has declined by 154 housing loans, given the lower risk of default and bps since March 2020 with a perceptible moderation the availability of collateral. Other personal loans, in shorter tenor deposits of up to one-year maturity i.e., loans other than housing, vehicle and education (180 bps) (Chart IV.30b). Consequently, the weighted are mostly unsecured and carry higher credit risk, average domestic term deposit rate (WADTDR) on mirrored in higher spreads (Chart IV.28). outstanding rupee deposits declined by 135 bps during the period March 2020 to August 2021. The The WALRs in respect of fresh rupee loans in the retail median saving deposit rate for domestic banks, which segment and loans to MSMEs declined significantly had remained sticky at 3.5 per cent during October during the period October 2019-August 2021 (Chart IV.29). Table IV.4: Loans Linked to External Benchmark – In respect of fresh rupee loans linked to the policy repo Spread of WALR (Fresh Rupee Loans) over the Repo rate, the spread – WALR (fresh rupee loans) over the Rate (August 2021) (Per cent) repo rate – charged by domestic banks during August Personal Loans 2021 was the lowest in the case of housing loans and Housing Vehicle Education Other MSME the highest in the case of other personal loans, in line personal loans loans with their risk profiles. The spreads charged by PSBs Public sector banks 3.20 3.56 4.40 5.04 4.83 for vehicle and education loans were lower than those Private sector banks 3.19 3.89 6.07 4.31 3.97 of private banks, while they were higher for MSME Domestic banks 3.19 3.60 4.75 4.98 4.47 loans and other personal loans (Table IV.4). Source: RBI. 74Chapter IV Financial Markets and Liquidity Conditions Chart IV.30: Credit, Surplus Liquidity and Deposit Rates a: Deposit Rate, Credit Growth and b: Maturity wise Transmission to Median Term Liquidity Conditions Deposit Rate (March 2020 to September 2021) Sources: RBI; and RBI staff estimates. 2017 to May 2020, declined to 3 per cent in June 2020 The Government has left the interest rates on and has remained at the same level since then. various small savings instruments unchanged since Q2:2020-21. The currently prevailing rates are 47-178 Amongst domestic banks, PvBs have exhibited higher bps higher than the formula-based rates for Q3:2021- pass-through to term deposit rates compared to PSBs, 22 (Table IV.5). resulting in some convergence in the levels of their deposit rates (Chart IV.31). With the moderation in interest rates on bank deposits Interest rates on small saving schemes are and unchanged interest rates on small savings, administered by the Government of India and are the latter have become attractive to depositors. fixed on a quarterly basis at a spread of 0-100 bps The growth in accretions under small savings has over and above G-sec yields of comparable maturities. consistently been above that of bank deposits since Chart IV.31: Term Deposit Rates a: WADTDR on Outstanding Rupee Term Deposits b: Median Term Deposit Rates on Fresh Deposits Source: RBI. 75Monetary Policy Report October 2021 Table IV.5: Interest Rates on Small Savings Instruments – Q3:2021-22 Small Savings Scheme Maturity Spread Average G-sec Yield Formula based Government Difference (years) (Percentage (%) of Corresponding Rate of Interest Announced Rate (basis points) point) $ Maturity (June 2021 - (%) (applicable of Interest (%) in August 2021) for Q3:2021-22) Q3:2021-22 (1) (2) (3) (4) (5) = (3) + (4) (6) (7) = (6) - (5) Savings Deposit - - - - 4.00 - Public Provident Fund 15 0.25 6.38 6.63 7.10 47 Term Deposits 1 Year 1 0 3.72 3.72 5.50 178 2 Year 2 0 4.23 4.23 5.50 127 3 Year 3 0 4.74 4.74 5.50 76 5 Year 5 0.25 5.76 6.01 6.70 69 Recurring Deposit Account 5 0 4.74 4.74 5.80 106 Monthly Income Scheme 5 0.25 5.73 5.98 6.60 62 Kisan Vikas Patra 124 Months# 0 6.38 6.38 6.90 52 NSC VIII issue 5 0.25 5.89 6.14 6.80 66 Senior Citizens Saving Scheme 5 1.00 5.76 6.76 7.40 64 Sukanya Samriddhi Account Scheme 21 0.75 6.38 7.13 7.60 47 $: Spreads for fixing small saving rates as per Government of India Press Release of February 2016. #: Current maturity is 124 months. Note: Compounding frequency varies across instruments. Sources: Government of India; FBIL; and RBI staff estimates. 2018 and the gap has widened, with implications for IV.3 Liquidity Conditions and the Operating monetary transmission as and when credit demand Procedure of Monetary Policy picks up (Chart IV.32). The RBI Act, 1934 requires the Reserve Bank to place the operating procedure relating to the implementation Chart IV.32: Deposits of Scheduled Commercial of monetary policy and changes thereto from time Banks and Small Savings to time, if any, in the public domain. In consonance with the MPC’s accommodative stance, the Reserve Bank continued with liquidity easing measures during H1:2021-22, aimed at nurturing and supporting the nascent growth impulses. The RBI announced a secondary market G-sec acquisition programme or G-SAP 1.0 in April 2021, with a commitment to a specific amount of open market purchases of government securities. The G-SAP is unconventional on several counts. First, the RBI commits upfront the amount to be purchased in contrast to regular OMO purchases which are discretionary. Second, it entails continued support to the market in view of the large Source: RBI staff estimates. government borrowing programme. Third, the size 76Chapter IV Financial Markets and Liquidity Conditions of the purchases is significantly larger than OMOs Drivers and Management of Liquidity in normal times, thus boosting demand for G-secs During Q1:2021-22, currency expansion, build-up amidst elevated supply during 2021-22. of GoI cash balances and the restoration of the cash During Q1, the RBI conducted three auctions under reserve ratio (CRR) to its pre-pandemic level were the G-SAP 1.0 and purchased G-secs (including SDLs) of main sources of liquidity leakage while its accretion `1.0 lakh crore, in line with the announced amount. was through G-SAP and forex purchases (Table IV.7). In Q2, six auctions were conducted under G-SAP 2.0 Surplus liquidity – as reflected in average daily aggregating `1.2 lakh crore. The G-SAP 2.0 auctions net absorptions under the LAF – amounted to conducted on September 23 and September 30, `5.1 lakh crore. 2021 for `15,000 crore each were accompanied by simultaneous sales of G-secs of identical amount. Table IV.7: Liquidity – Key Drivers and Management (` crore) Overall, net liquidity injected through OMO 2020-21 Q1: Q2: H1: purchases, including G-SAP, amounted to `2.4 lakh 2021-22* 2021-22* 2021-22* crore in HI. Under the G-SAP, the RBI purchased Drivers both on the run (liquid) and off the run (illiquid) (i) CiC -4,06,452 -1,26,266 55,005 -71,261 securities across the maturity spectrum, with more (ii) Net forex purchases 5,10,516 1,60,843 1,42,395 3,03,238 (iii) GoI cash balances 1,18,999 -2,23,740 -5,600 -2,29,340 than 68 per cent of the purchases concentrated in Management over 5 to 10-year maturity segment, thus imparting (i) Net OMO purchases 3,13,295 1,38,965 97,960 2,36,925 liquidity to securities across the term structure (ii) CRR balances -1,46,617 29,392 -16,470 12,922 (iii) Net LAF operations -152,302 -60,759 -2,86,162 -3,46,921 (Table IV.6). By containing volatility in G-sec yields – the Memo; benchmarks for the pricing of other financial market 1. Average daily instruments – G-SAP helped to keep interest rates injection (LTRO, TLTRO, On tap 1,58,491 82,948 84,488 83,722 benign, thereby facilitating monetary transmission. TLTRO, SLTRO and MSF) 2. Average daily total 6,54,645 5,93,181 8,10,096 7,02,231 Table IV.6: G-SAP- Maturity Profile absorption (i+ii) (i) Fixed rate Residual Type of G-SAP 1.0 G-SAP 2.0 reverse repo 6,13,700 4,10,747 5,23,626 4,67,495 Maturity security (Years) Face value Share Face value Share (ii) Variable rate of G-sec in total of G-sec in total reverse repo 40,945 1,82,434 2,86,470 2,34,736 purchased purchases purchased purchases (VRRR) (` crore) (per cent) (` crore) (per cent) 3. Average daily net absorption during 4,96,154 5,10,233 7,25,609 6,18,509 Up to 5 On the run - - 6,885 5.7 the period (2-1) Off the run 17,541 18.5 7,019 5.8 4. Outstanding total Total 17,541 18.5 13,904 11.6 injection at the end 82,963 83,307 85,509 85,509 Over 5 On the run 42,635 45.1 4,377 3.6 of the period to 10 Off the run 20,774 22.0 79,763 66.5 5. Outstanding total absorption at the 4,93,904 6,85,828 9,14,463 9,14,463 Total 63,409 67.0 84,140 70.1 end of the period Over 10 On the run 5,882 6.2 15,973 13.3 6. Outstanding net to 14 Off the run 7,743 8.2 5,984 5.0 absorption at the 4,11,211 6,02,521 8,28,954 8,28,954 Total 13,625 14.4 21,957 18.3 end of the period Grand Total 94,575* 100.0 1,20,001 100.0 *: Data on drivers and management are based on the last Friday of the *: Total purchases made under G-SAP 1.0 amounted to `1.0 lakh crore, respective periods. which includes G-sec of `0.95 lakh crore and SDLs of `0.05 lakh crore. Note: Inflow (+)to/outflow (-) from the banking system. Source: RBI Source: RBI 77Monetary Policy Report October 2021 Lower liquidity leakage due to subdued currency Chart IV.33 Currency in Circulation expansion added to the persistence of large surplus liquidity in H1:2021-22 (Chart IV.33). Despite the second wave of the pandemic being more virulent, the precautionary demand for cash remained muted. In Q2, the usual return of currency during the monsoon season, renewed vigour of capital inflows along with liquidity injections through G-SAP 2.0 augmented surplus liquidity. As a result, average daily net liquidity absorptions in Q2 soared to `7.3 lakh crore. Unabated capital inflows reflected on the forward premium curve in the forex market – its shape being determined by the interplay of institutional features and regulatory aspects with the market microstructure Source: RBI. and flow factors, apart from macroeconomic fundamentals (Box IV.2). Box IV.2: Determinants of Forward Premia – A Macro-Finance Approach According to the covered interest rate parity (CIP) be decomposed into its latent factors – level, slope and condition, the forward premium reflects the interest curvature. An analysis based on monthly data (January rate differential between two currencies of comparable 2015 to June 2021) for tenors spanning 1-12 months maturity and risk profile. Capital controls and varying indicates that the first three principal components (PCs) risk perceptions of investors can, however, lead to a explain more than 99 per cent of the variation in the wedge in this relationship. Qualitative attributes (such data. The three PCs characterise the level, the slope and as market sentiments, expectations, political stability the curvature, respectively, of the forward premium and financial news) and quantitative factors (like crude curve.10 oil prices, central bank’s forex intervention and foreign The determinants of forward premia for three tenors exchange market turnover) also impact forward premia viz., 1-month, 3-months and 12-months are separately (Srikanth and Chittedi, 2014). While interest rate short-listed using a machine learning approach (random differentials explain the forward premia in the long-run forest11 methodology) (Dilip et al, 2021). These variables in line with CIP, the volatility in the spot rate influences are: (i) the differential between yields on 3-month T-bills it in the short-run (Biswas et al, 2018). Drawing upon for US and India (Int_Diff); (ii) domestic system liquidity the macro-finance literature on modelling the shape of as proportion to GDP (Net_LAF); (iii) global economic the yield curve through principal component analysis policy uncertainty index (GEPU); (iv) RBI’s forward (Diebold et al, 2006), the forward premium curve can (Contd.) 10 The level is the weighted sum of changes in forward premia rates with the same sign across all maturities; a level shock changes the rates by identical amounts across all maturities, indicating a parallel shift of the forward premia curve. The slope weighs changes in rates for short maturities with a negative sign and those of medium and long maturities with a positive sign. Finally, the curvature associates positive signs with short and long-term changes but negative signs with medium-term rate changes; a disproportionate shock to the medium-term rates vis-a-vis the short and long term rates impacts the hump of the curve (Litterman and Scheinkman, 1991). 11 A random forest is a supervised machine learning algorithm that assesses the relative importance of each variable on the prediction. 78Chapter IV Financial Markets and Liquidity Conditions intervention (net forward purchases) as proportion of (Table IV.2.1). Stock market turbulence (captured by forex reserves (Forward_Intervention); (v) CPI inflation NIFTY volatility) is associated with a marginal hardening volatility (Vol_Inf); (vi) 3-month realised volatility of the level of the forward premia along with a steepening of NIFTY 50 (Vol_NIFTY50); and (vii) trade deficit as of the curve as traders seek to hedge their positions. The rise in the volatility in domestic inflation seems proportion to GDP [Trade_Deficit]. The generalized to increase risk aversion among market participants at method of moments (GMM) approach – more specifically, shorter and longer tenors, thus moderating the extent the continuously updating GMM estimation (CUE) of the hump in the forward premia curve. The increased methodology using appropriate instrument variables12 availability of domestic liquidity moderates the level – is deployed to address endogeneity concerns, after and shape of the forward premia curve. Finally, forward conducting due diligence for the time series properties interventions by the RBI seems to flatten the slope and of the variables. reduce the curvature while increasing the level of the The empirical results suggest positive and statistically premia. The analysis suggests that forward interventions generally discourage carry trade activities by reducing significant impact of interest rate differentials and global the steepness of the forward premia curve. In a situation uncertainty on the level of the forward premium curve of large surplus liquidity, a steeper curve can trigger a vicious cycle of higher inflows and even further increase Table IV.2.1: Determinants of the Forward in the forward premia. Premia Curve Explanatory (cid:39)Level Slope Curvature References Variables/Dependent Variable Biwas, D., S. Kumar, S., and A. Prakash (2018), “Do Spot Rate Volatility and Forward Market Intervention by the Lag of Dependent -0.40*(-1.97) 0.38***(4.57) 0.23***(3.16) Variable Central Bank Impact the Forward Premia in India?”, (cid:39)Int_Diff 0.64***(3.65) 0.20**(2.66) - Asian Journal of Economics, Finance and Management, (cid:39)Net_LAF -0.56***(-3.90) -0.15*(-1.73) -0.04***(-3.04) 1(1), pp 1-12. (cid:39)GEPU(-1) 0.003**(2.15) - - (cid:39)Forward_ 0.16*(1.77) -0.09**(-2.80) -0.03*(-1.69) Diebold, F., G. Rudebusch, G., and S. B. Aruoba (2006), Intervention “The Macroeconomy and the Yield Curve: A Dynamic Vol_NIFTY50 0.02***(3.81) 0.01**(2.85) - Latent Factor Approach”, Journal of Econometrics, 131(1- Vol_Inf - - -0.05*(-1.99) Trade_Deficit(-1) - 0.03**(2.37) 2), pp 309-338. Constant -0.32***(-2.90) -0.23***(-4.23) 0.15***(3.38) Dilip, A., P. Kumar, P. Sachdeva, K.M. Kushawaha and I. Adj R-squared 0.21 0.32 0.30 Diagnostics Bhattacharyya (2021), “Recent Movements in Forward J-Statistic (p-value) 0.55 0.95 0.44 Premia – An Analytical Perspective”, RBI mimeo. (Over-identification test) Litterman R. B., and J. Scheinkman, (1991) “Common Q-statistic (p-value) 0.36 0.12 0.28 Factors Affecting Bond Returns”, The Journal of Fixed (Serial correlation test Income, Summer, 1(1) 54-61. for 4 lags) Note: ***, **, and * indicate 1 per cent, 5 per cent and 10 per cent levels Srikanth, M. and K. R. Chittedi (2014), “Perspectives on of significance, respectively. Forward Premia in India Forex Market: A Study of USD/ Figures in parenthesis are t-statistics based on heteroscedasticity and autocorrelation consistent (HAC) corrected standard errors. INR”, Journal of Stock & Forex Trading, 3(4). 12 Apart from lagged variables as instruments, implied volatility of INR per USD rates for 3-months is used as an instrument variable for forward intervention; the residuals from regressing stock market volatility on policy uncertainty are used as an instrument for the stock market variable. 79Monetary Policy Report October 2021 Chart IV.34: Forward Intervention and Chart IV.35: Liquidity Absorption Forward Premia Source: RBI. Source: RBI. With the moderation of the forward book in by fine-tuning operations conducted through VRRRs H1:2021-22 (up to July), the pressure on the forward of 3, 4 and 7 days maturities. Notwithstanding the premia somewhat eased (Chart IV.34). phased increase in the size of VRRRs, the surplus liquidity absorbed through fixed rate reverse repo The gradual normalisation of liquidity management remained around `4.7 lakh crore (on an average) in operations in sync with the revised liquidity management framework instituted in February 2020 H1 (Chart IV.35). was a key feature of liquidity management during The enhancement in VRRR size was initially H1:2021-22. As a part of this process, the CRR was interpreted as a precursor to reversal of liquidity restored to its pre-pandemic level of 4.0 per cent of measures leading to a transient spike in G-sec yield on NDTL in two phases of 0.5 percentage point increase in the policy day, i.e., August 7, 2021 (Chart IV.36a). Such the fortnights beginning March 27, 2021 and May 22, fears, however, were unfounded as evident from the 2021. The surplus liquidity was mopped up through relative stability in the bid-cover ratios of 14-day VRRR the overnight fixed rate reverse repo and the VRRR auctions in the immediate fortnights after the policy auctions of varying maturities under the LAF. Keeping announcement vis-à-vis before (Chart IV.36b). in view the markets’ feedback and appetite for higher remuneration, the Reserve Bank enhanced the size of Reflecting the liquidity injections through G-SAP and the fortnightly VRRR auctions in a phased manner from capital inflows, reserve money (RM) increased by 14.7 `2.0 lakh crore during April-July to `2.5 lakh crore on per cent (y-o-y) as on September 24, 2021 (9.1 per cent August 13, 2021; `3.0 lakh crore on August 27, 2021; adjusted for the first-round impact of the change in `3.5 lakh crore on September 9, 2021; and `4.0 lakh the CRR) while money supply (M3) increased by 9.3 crore on September 24, 2021. These were supported per cent (y-o-y) as on September 24 (Table IV.8). 80Chapter IV Financial Markets and Liquidity Conditions Chart IV.36: Variable Rate Reverse Repo Auctions a: 10-year G-sec Yield: Intra-day Movement on b: Bid-Cover Ratios August 7, 2021 Source: RBI, and Bloomberg Other Liquidity Measures Table IV.8: Key Banking and Monetary Aggregates in H1:2021-22 Apart from G-SAP, the RBI continued with measures Indicator Variation (in ` Crore ) to meet targeted sectoral credit needs to nurture the Financial Year Y-o-Y nascent economic recovery in H1. These measures 2020-21 2021-22 2020-21 2021-22 included (i) special refinance facilities of `66,000 crore Reserve money 1,59,682 59,318 4,01,195 4,69,910 to all-India financial institutions (AIFIs) comprising (5.3) (1.6) (14.4) (14.7) [18.6]* [9.1]* `25,000 crore to the National Bank for Agriculture Currency in circulation 2,35,646 71,261 4,96,810 2,42,067 (9.6) (2.5) (22.7) (9.0) and Rural Development (NABARD); `10,000 crore to Broad money (M3) 9,39,801 5,47,546 19,25,597 16,52,360 the National Housing Bank (NHB); and `31,000 crore (5.6) (2.9) (12.2) (9.3) to the Small Industries Development Bank of India Aggregate deposits 6,94,911 4,81,525 13,55,943 13,32,634 (5.1) (3.2) (10.5) (9.3) (SIDBI) to support and nurture the recovery; (ii) term Demand deposits -40,943 -38,221 1,67,175 2,46,911 liquidity facility of `50,000 crore to ramp up COVID- (-2.5) (-2.1) (11.9) (15.7) Time deposits 7,35,854 5,19,746 11,88,768 10,85,722 related healthcare infrastructure and services in (6.2) (3.9) (10.3) (8.6) the country; (iii) special long-term repo operations Bank credit -99,280 7,283 5,04,727 6,85,211 (-1.0) (0.1) (5.2) (6.7) (SLTRO) for small finance banks (SFBs) of `10,000 *: Growth rates adjusted for the first-round impact of the change in CRR. crore to be deployed for fresh lending of up to `10 Note: 1. Figures in parentheses indicate percentage change. 2. Data on deposits and bank credit pertains to scheduled lakh per borrower; (iv) on-tap liquidity window of commercial banks (SCBs). `15,000 crore in order to mitigate the adverse impact 81Monetary Policy Report October 2021 of the second wave of the pandemic on certain Table IV.9: Liquidity Measures since contact-intensive sectors13. Overall, the Reserve February 6, 2020 (As on September 30, 2021) Bank has announced liquidity enhancing measures Measure Announced Amount (` crore) worth `17.2 lakh crore (8.7 per cent of nominal GDP of 2019-20 2020-21 2021-22 Overall 2020-21) since February 6, 2020 (Table IV.9). (1) (2) (3) (4 =1+2+3) IV.4 Conclusion LTRO 2,00,000 2,00,000 Variable rate repo 1,75,000 50,000 2,25,000 Domestic financial markets broadly remained stable SLF for PDs 7,200 7,200 and in sync with the accommodative policy stance of CRR cut 1,37,000 1,37,000 the MPC and the Reserve Bank’s continued calibrated MSF (dip by additional 1% 1,37,000 1,37,000 in SLR) liquidity injection measures. Market activity was TLTRO 25,000 75,000 1,00,000 vibrant, with short-term rates easing appreciably along TLTRO (2.0) 50,000 50,000 with thinning of spreads. The renewed vigour of capital Net OMO purchases 40,000 1,10,000 2,20,000 3,70,000 including G-SAP inflows and the infusion of discretionary liquidity Special liquidity facility for 50,000 50,000 through G-SAP resulted in a substantial increase in mutual funds surplus systemic liquidity, which was modulated Refinance to NABARD, SIDBI, 75,000 66,000 1,41,000 NHB and EXIM Bank through increases in VRRR amounts and fine-tuning Special liquidity scheme for 30,000 30,000 NBFCs operations. Monetary transmission improved further 56-day term repo 1,00,000 1,00,000 amidst nascent signs of an upturn in credit growth. On Tap TLTRO 1,00,000 1,00,000 Going forward, liquidity conditions are expected to SLTRO for small finance banks 10,000 10,000 continue to be accommodative in consonance with the Term liquidity facility to ease access to emergency health 50,000 50,000 monetary policy stance, through calibrated liquidity services management operations. Imparting momentum to the On-tap liquidity window for 15,000 15,000 contact-intensive sectors nascent economic recovery process and putting it on Total 7,21,200 6,40,000 3,61,000 17,22,200 a sustained and durable basis through efficient policy As per cent of nominal GDP 8.7 for 2020-21 transmission would continue to assume primacy in Source: RBI the hierarchy of policy objectives. 13 As an incentive, banks were permitted to park their surplus liquidity up to the size of the loan book created under this scheme with the Reserve Bank under the reverse repo window at a rate which is 25 bps lower than the repo rate i.e., 40 bps higher than the reverse repo rate. 82Chapter V External Environment V. External Environment The global economic activity gained traction in Q2:2021 (April-June). In Q3, however, the momentum of the global recovery seems to have weakened across the board as the rapid spread of more virulent strains of the virus weighed on business conditions. Elevated commodity prices and overstretched supply chains are keeping input price pressures high, posing upside risks to headline inflation. The divergence in monetary policy actions and stances is amplifying the unequal and uneven nature of the global recovery and increasing the downside risks to the outlook, while global financial markets are turning volatile. In the aftermath of the April 2021 MPR, daily The US dollar has strengthened in anticipation of new infections appeared to have peaked in major taper and higher inflation outcomes in the US. advanced economies (AEs) and a few emerging market V.1 Global Economic Conditions economies (EMEs), allowing easing of restrictions and Economic activity accelerated in major AEs and EMEs global economic activity to gain traction in Q2:2021 in Q2:2021, but faltered in Q3, with most economies at a diverging and unequal pace on the basis of scale yet to return to their pre-pandemic levels. In the US, and speed of vaccination. Starting June, however, the economic rebound that commenced in H2:2020 the momentum of the global recovery seems to have continued into H1:2021, with GDP bouncing back weakened across the board as the rapid spread of to its pre-pandemic level in Q2:2021 (Table V.1). more virulent strains of the virus weighed on business Sustained policy support, easing of restrictions and conditions in most major economies, pulling down vaccination supported a strong pick-up in consumer global purchasing managers’ index (PMI) readings and is likely to reflect in lower GDP growth in Q3. Besides, spending. Non-farm payroll showed signs of steady still rising commodity prices and overstretched supply improvement during May-July indicating the mending chains are keeping input price pressures high, posing of labour market conditions; however, it softened in upside risks to headline inflation. Several EME central August to a seven-month low amidst rising infections. banks and a few in the AEs have responded with Employment remains below the pre-pandemic level policy rate hikes and unwinding of policy stimulus. and the Federal Reserve (Fed)’s goal of maximum The divergence in monetary policy actions and stances employment, beset with hiring difficulties and labour is amplifying the unequal and uneven nature of the supply shortages. Incoming data for Q3 also suggest global recovery and increasing the downside risks to that the momentum of growth may have moderated the outlook. – consumer sentiment plummeted in August to its lowest level in nearly a decade due to surging delta Global financial markets remained buoyant up to variant infections and inflation concerns, before rising early-September before increasingly turning volatile. marginally in September. The manufacturing PMI Even as stock markets in a few countries scaled fresh eased in July due to persistent supply side frictions peaks in September 2021, most saw sharp correction. but improved in the next two months even as the In the bond markets, yields remained range-bound up rising infections caseload weighed on the outlook. to August in most AEs but rose sharply in September. In EMEs, bond yields moved bi-directionally but rose After slipping into a double dip recession in Q1:2021, in the latter part of September, in sync with the AEs. the Euro area rebounded sharply in Q2, growing at 8833Monetary Policy Report October 2021 manufacturing PMI, while services PMI fell to a four- Table V.1: Real GDP Growth (Per cent) month low in September. Country Q2- Q3- Q4- Q1- Q2- 2020 2021 2022 2020 2020 2020 2021 2021 (P) (P) The Japanese economy picked up in Q2 at a pace higher Quarter-over-quarter, seasonally adjusted, annualised rate than expected, but much weaker than other major (Q-o-q, SAAR) AE peers. Resilient external demand underpinned a Canada -38.0 41.7 9.3 5.5 -1.1 - - - recovery in exports and capital expenditure. In Q3, Euro area -39.1 60.9 -1.7 -1.1 9.2 - - - Japan -28.1 23.2 11.9 -4.2 1.9 - - - however, the country is less likely to maintain this UK -58.1 90.2 4.5 -5.3 23.9 - - - momentum as the upsurge in cases of more virulent US -31.2 33.8 4.5 6.3 6.7 - - - strains pushed the economy into its fourth state of Year-on-year (Y-o-y) Advanced Economies emergency in early July which was extended till Canada -12.6 -5.1 -3.1 0.3 12.7 -5.3 6.3 4.5 September. The fallout from the renewed wave is Euro area -14.5 -4.0 -4.4 -1.2 14.3 -6.5 4.6 4.3 already getting reflected in incoming data as industrial Japan -10.1 -5.5 -0.9 -1.3 7.6 -4.7 2.8 3.0 UK -21.4 -8.1 -7.1 -5.8 23.6 -9.8 7.0 4.8 growth turned weaker in July and August and the US -9.1 -2.9 -2.3 0.5 12.2 -3.5 7.0 4.9 manufacturing PMI, though in expansion zone, Emerging Market Economies moderated in Q3. The composite PMI remained in Brazil -10.9 -3.9 -1.1 1.0 12.4 -4.1 5.3 1.9 contraction zone up to September, reflecting a sharp China 3.2 4.9 6.5 18.3 7.9 2.3 8.1 5.7 India -24.4 -7.4 0.5 1.6 20.1 -7.3 9.5 8.5 deterioration in business activity in the services Indonesia -5.3 -3.5 -2.2 -0.7 7.1 -2.1 3.9 5.9 sector. Philippines -17.0 -11.6 -8.3 -3.9 11.8 -9.6 5.4 7.0 Russia -7.8 -3.5 -1.8 -0.7 10.5 -3.0 4.4 3.1 In the UK, GDP grew sharply in Q2:2021 – as against a South Africa -16.8 -5.8 -3.5 -2.6 19.3 -7.0 4.0 2.2 contraction in Q1 – as the gradual rollback of COVID- Thailand -12.1 -6.4 -4.2 -2.6 7.5 -6.1 2.1 6.1 Memo: 2020 2021 (P) 2022 (P) related restrictions together with rapid vaccine rollouts World Output -3.2 6.0 4.9 aided a strong rebound in household consumption and World Trade -8.3 9.7 7.0 public spending. With increasing caseload intensifying Volume the risk of another round of lockdown restrictions, P: Projection. Note: India's data correspond to fiscal year (April-March). the pace of recovery slowed in Q3. The composite PMI Sources: Official statistical agencies; Bloomberg; IMF WEO Update, July 2021; and RBI staff estimates. eased for the fourth consecutive month in September as output growth in both manufacturing and services weakened amidst stringent supply constraints. 9.2 per cent [q-o-q, seasonally adjusted annualised The Chinese economy expanded by 7.9 per cent (y-o-y) rate (SAAR)], as most major constituent economies in Q2. Successful containment of several sporadic returned to growth following gradual withdrawal of restrictions. Significant progress on vaccination, virus outbreaks together with sustained policy together with falling rates of incidence, boosted measures kept exports and manufacturing activity consumer and business sentiments, and brightened well supported, thus powering a steady recovery. the prospects for domestic demand and employment. Domestic consumption, however, remains a weak In Q3, however, the economy seems to have lost some spot and the economy exhibited signs of slowing steam, as evident from high frequency indicators. down in Q3. Both manufacturing and services PMI The composite PMI, though in strong expansion, slipped back into contraction in August for the first moderated in August and September from its 15-year time since April 2020 following the deterioration in high in July, as capacity constraints dragged on the business conditions. In September, manufacturing 8844Chapter V External Environment PMI had the neutral reading of 50, i.e., neither paced up vaccination having boosted sentiments. expansion nor contraction. The deterioration in real Manufacturing PMI moderated in August but picked estate, rising input costs, regulatory crackdown on up in September, with production rising for the fifth corporates in recent months and growing power successive month owing to a robust expansion in outages are the major headwinds. sales. An examination of key macroeconomic indicators of The Russian economy remained resilient with GDP BRICS economies reveals that the macroeconomic having reached its pre-pandemic level in Q2:2021. performance of India is likely to remain resilient in A sustained recovery in consumer spending and 2021 when compared with most other counterparts investment demand supported the uptrend, while (Table V.2). elevated commodity prices and the gradual recovery The Brazilian economy contracted marginally on q-o-q of oil output lent further support. Some slowing basis in Q2:2021, reversing three successive quarters of momentum is evident in Q3 as a third wave of of sequential expansion since Q3:2020. Contraction infections since end-June impacted both domestic in both industry and agricultural sectors on account and foreign demand conditions leading to a decline in of the resurgence of COVID-19 infections, weighed production and slowdown in new order growth. The on economic activity. On the demand side, a sharp manufacturing PMI is back into the contraction zone decline in gross fixed capital investment, together with since June, while the composite PMI recorded its first muted household consumption, led to the downturn. contraction since December 2020 in August but was In Q3, indicators are pointing to mobility gains, with back in expansion zone in September. Table V.2: Select Macroeconomic Indicators for BRICS Real GDP growth Country 2020 2021(P) 2022(P) General Govt. Country 2020 2021(P) 2022(P) rate (per cent) Brazil -4.1 5.3 1.9 gross debt (as Brazil# 98.9 91.8 98.8 per cent of GDP) Russia -3.0 4.4 3.1 Russia 19.3 18.0 17.7 India -7.3 9.5 8.5 India 89.4 90.1 86.3 China 2.3 8.1 5.7 China 66.3 70.3 73.7 South Africa -7.0 4.0 2.2 South Africa 77.1 77.5 84.4 CPI inflation rate Country 2020 2021(P) 2022(P) Current account Country 2020 (P) 2021(P) 2022(P) (per cent) Brazil 3.2 4.6 4.0 balance (as per Brazil -0.9 -0.6 -0.8 cent of GDP) Russia 3.4 4.5 3.4 Russia 2.2 3.9 3.3 India 6.1 @ 4.9 4.1 India 1.0 -1.2 -1.6 China 2.4 1.2 1.9 China 2.0 1.6 1.3 South Africa 3.3 4.3 4.5 South Africa 2.2 -0.4 -1.5 General Govt. net Country 2020 (P) 2021(P) 2022(P) Forex reserves* Country 2020 2021 lending/borrowing Brazil -13.4 -8.3 -7.2 (in US$ billion) Brazil 355.6 370.4 (as per cent of Russia -4.1 -0.8 -0.3 Russia 596.1 618.2 GDP) India -12.3 -10.0 -9.1 India 588.4 633.6 China -11.4 -9.6 -8.7 China 3536.0 3588.1 South Africa -12.2 -10.6 -8.3 South Africa 54.2 58.3 P: Projection. *: Forex reserves for 2021 pertain to August 2021. #: Gross debt refers to the nonfinancial public sector, excluding Eletrobras and Petrobras, and includes sovereign debt held by the central bank. @: Average of the period from June 2020 to March 2021. Note: India's data correspond to fiscal year (April-March). Sources: Bloomberg; Official statistical agencies; WEO April 2021 database and July 2021 Update; and IRFCL, IMF. 8855Monetary Policy Report October 2021 The South African economy has exhibited gradual The OECD composite leading indicators (CLIs) recovery with four consecutive quarters of q-o-q available up to August 2021 suggest moderate improvement just above trend level across most expansion up to Q2:2021. The recovery was major AEs, while for major EMEs it reflects diverging underpinned by strong growth in transport and developments (Chart V.1a). The global composite PMI communication, personal services and the agricultural has moderated within the expansion zone, hitting a sector, while household spending and exports lent 7-month low in August, before rising marginally in support. In Q3, however, the pace of growth is likely to September with PMI manufacturing remaining flat have decelerated as social unrest, mounting infections, (Chart V.1b). slow vaccine rollouts and power outages weakened Global trade showed signs of revival during Q4:2020 business conditions as also domestic demand. and recovered swiftly during H1:2021 across AEs and Among the South-East Asian economies, recovery EMEs (Chart V.2a). Following the recent resurgence in global trade, the WTO has revised its growth forecast remains slow-paced with renewed waves of contagious of merchandise trade volume to 10.8 per cent for strains of COVID-19 amidst lagged inoculation rates. 2021. However, persisting worldwide shortages in Stringent containment measures have resulted semiconductors and port congestion may moderate in deterioration of business conditions, pushing global trade recovery in certain sectors (Box V.1). The manufacturing PMI for all major ASEAN economies Baltic Dry Index, which measures shipping costs for into contraction territory in August, for the first time a wide variety of bulk commodities such as coal, iron since May 2020. The PMI manufacturing for the ASEAN ore and grain, rose to a new high by end-September region was at the neutral level of 50 in September. (Chart V.2b). Chart V.1: High Frequency Indicators a: OECD CLIs b: Composite PMI Sources: OECD; and Bloomberg. 8866Chapter V External Environment Box V.1: Global Semiconductor Shortage: Opportunities and Challenges The world is currently facing an acute shortage of incentives to scale up their domestic semiconductor semiconductors, which is the fourth most traded item manufacturing capacity (Chart V.1.1b). Furthermore, globally after crude oil, refined oil and cars (BCG-SIA leading semiconductor manufacturers like TSMC and Report, 2021). The global semiconductor market is valued Intel have also planned huge capital expenditure to the at US$440 billion accounting for around 5 per cent of tune of US$100 billion and US$43.5 billion, respectively, global goods trade and is expected to grow by 25.1 per to tap the elevated demand. The recent investment boom cent (US$551 billion) in 2021, driven by key segments to meet shortages may lead to overcapacity in the long such as mobile phones, information and communications run. technology (ICT) infrastructure, personal computers, The semiconductor industry is at the core of India’s industrial applications, consumer electronics and digital transformation into a US$1 trillion digital automobiles (Chart V.1.1a). The buoyant demand for economy by 2025. The size of the world market for 111 electronic gadgets, cloud computing solutions and auto frontier technologies is expected to increase to US$3.2 industry following COVID-19 pandemic led to a huge trillion by 2025 (UNCTAD, 2021) and drive the demand supply-demand mismatch in the semiconductor industry, for semiconductors in future. Moreover, the share of causing production delays and inflationary pressures software-related automotive electronics in car industry is across segments forcing companies to reinvent their estimated to increase from 27 per cent in 2010 to 45 per supply chains. Alix Partners (2021) estimates that the cent by 2030 (Deloitte, 2019). ongoing semiconductor shortage may lead to revenue The semiconductor industry is highly capital-intensive loss of around US$210 billion in 2021 in the automotive with a long gestation period. Annual energy requirements sector. According to Gartner (2021), normalcy is expected to run large fabrication facilities are estimated at around to return to semiconductor industry by the second quarter 169 MWh, sufficient to power an Indian city (Kumar, 2021). of 2022. Moreover, it requires on average 2-4 million gallons of ultra- Realising critical geo-political concerns associated with pure water daily (Baskaran, 2017). Furthermore, wastage semiconductor industry, countries are offering huge disposal associated with semiconductor industry is also Chart V.1.1: Snapshot of Global Semiconductor Industry a. Semiconductors Demand by End Use (2019, Per cent) b. Domestic Support to Semiconductor Industry by Major Economies *: The incentives for South Korea and the European Union are estimated at US$55-65 billion (over three years) and US$20-35 billion (over ten years), respectively. The financial incentive for China is for ten years. Sources: SIA-BCG Report and various SIA releases. (Contd.) 1 Artificial intelligence, internet of things, big data, blockchain, 5G, 3D printing, robotics, drone, gene editing, nanotechnology and solar photovoltaic. 8877Monetary Policy Report October 2021 capital intensive and raises environmental concerns. The semiconductor industry is also highly cyclical in nature and determined by two variables, namely semiconductor where is defined as the growth rate of worldwide inventory and fabrication plant capacity (Liu W. H., 2005). semiconductor sales. The equations (1) - (5) represent the Using a Markov regime-switching model, the expected model set up as an AR (4) process where stands duration of an expansionary cycle (8 months) is obtained for expansion of the semiconductor industry and as twice that of a contractionary phase (4 months) (Liu stands for contraction of the semiconductor industry. and Chyi, 2006). We extend that line of analysis to the The transition probability from expansion to expansion period September 2003 to June 2021 with the following (i.e., from to ) is defined as p. On the empirical specification: other hand, the transition probability from contraction to contraction ( to ) is defined as q. The empirical results suggest that the expected duration of expansion and contraction in the semiconductor industry is around 16 months and 4 months, respectively. The higher expansionary period reflects the increasing demand for semiconductors across industries post COVID-19 (Charts V.1.2a and V.1.2b). Chart V.1.2: Semiconductor Industry a. Growth Rate of Worldwide Semiconductor Sales (3-month Moving Average Seasonally Adjusted) b. Probability of Semiconductor Industry Being in Contraction Probability of the semiconductor industry being in contraction with initial p=0.5, q=0.5 Sources: World Semiconductor Trade Statistics; and RBI staff estimates. (Contd.) 8888Chapter V External Environment Given the renewed focus on digitalisation and increasing Select References domestic demand for electronic goods with large Kumar, M. J. (2021). Is India going to be a major hub of import dependency, the government has initiated the semiconductor chip manufacturing? IETE Technical Production Linked Incentive (PLI) scheme and Scheme for Reviews, 279-281. Promotion of Manufacturing of Electronic Components and Semiconductors (SPECS) to encourage its domestic Liu, W. H. (2005). Determinants of the semiconductor production. Incentives in line with those provided by industry cycles. Journal of Policy Modelling, 27 (2005), major countries would help develop semiconductor 853-866. fabrication facilities in India. Fiscal incentives and Liu, W.H., & Chyi, Y.L. (2006). A Markov regime-switching provision of adequate infrastructure like uninterrupted model for the semiconductor industry cycles. Economic supply of electricity and ultra-pure water could contribute Modelling, 23 (2006), 569-578. to India’s emergence as a major player in this industry UNCTAD. (2021). Technology and Innovation Report. and provide a conducive environment for the hardware segment to complement the software industry. V.2 Commodity Prices and Inflation of seasonal production gains and softening import demand. In contrast, sugar and meat prices have Global commodity prices have soared in 2021 so continued to increase due to tightening supplies from far, with intermittent corrections – the Bloomberg major exporters amidst rising import demand. commodity price index increased by 20.7 per cent during April-September 2021. The food price index Crude oil prices rallied unevenly since April on of the Food and Agriculture Organization (FAO) improved demand prospects. Brent crude crossed increased by 7.0 per cent between March and August US$70 per barrel in June, reaching its then highest 2021 (Chart V.3a). Prices of vegetable oil, cereal and level of 2021 in early July. From the second week dairy sub-indices have eased more recently because of July, however, crude oil prices turned volatile – Chart V.2: World Trade Volume a: World Trade Volume: Relative Contribution b: Movement in World Trade Volume and Baltic Dry Index Sources: CPB Netherlands; and CEIC. 8899Monetary Policy Report October 2021 Chart V.3: Commodity Prices a: Food Price Indices b: Energy and Crude Oil Prices Sources: Food and Agriculture Organization; and World Bank. downward bias was imparted by rapid spread of the prices rose in April and May on strong safe haven contagious delta variant, OPEC plus agreement to ease demand, but lost sheen in June on account of a strong supply with an additional output of 400,000 barrels US dollar. After remaining range-bound around per day each month from August and rising stockpiles the psychological level of US$1,800 per troy ounce in the US. Price have firmed up since the latter part during July to early September, prices plummeted in of August on tightening US supplies owing to slow September with sharp rise in the US treasury yields recovery from disruption caused by Hurricane Ida and and the US dollar. lower stockpiles in China. Brent crude prices ruled at nearly three-year highs at end-September, surging by Chart V.4: Metal Price Indices 54.0 per cent on year-to-date basis. Base metal prices measured by the Bloomberg’s base metal spot index increased by 11.4 per cent during April-September 2021. The strong rally in prices witnessed in Q1:2021 continued into the first half of Q2 (Chart V.4). Most industrial metals, including copper and iron peaked in mid-May. The steady recovery in manufacturing activity across most major economies, along with rising supply bottlenecks, underpinned the metals bull run of H1:2021, sparking a debate on potential emergence of a fresh commodity super-cycle (Box V.2). Thereafter, prices for most metals have turned volatile in Q3, with iron giving up all early Source: Bloomberg. gains following China’s pro-climate measures. Gold 9900Chapter V External Environment Box V.2: Global Commodity Prices: Is a Super Cycle Forming? Global commodity markets have picked up momentum Fitzgerald band-pass (BP) filter was deployed to decompose in 2021, with a 69.4 per cent increase in the Bloomberg real metal prices (RP) into three components2: a long term commodity price index from the low of March 2020 (Chart trend (RP_LTT); a super cycle component (RP_SC); and V.2.1a). Metal prices have remained the frontrunner in other relatively shorter cyclical components (RP_STC) the recovery (Chart V.2.1b). Prices of iron and tin surged such that: to historic peaks, while copper and aluminium recorded over a decadal high as recovering demand was further propelled by speculative trading. In line with Heap’s (2005) analysis, a super cycle ranges from 20 to 70 years and, therefore, a BP (20,70) filter has Super cycles are long-period cycles with periods of price been applied on each price series to obtain its super cycle upswings of roughly 10-35 years, and are generally component. The long run trend is defined as a cyclical perceived to be broad-based, affecting a wide range of component with periods above 70 years and is extracted commodities (Heap, 2005). They are rare but long-lasting. using a BP (70,(cid:102)) filter3, while short-term cyclical Such elongated cycles are attributed to structural shifts in components are defined as cycles with periods of 2 to 20 the economy, characterised by prolonged period of strong years and extracted by using BP (2,20) filter. demand outpacing supply. Three demand-driven super cycles have occurred since the late 19th century: during the The results corroborate the occurrence of three super US industrialisation which began in late 1800s through cycles since the late 1800s (Chart V.2.2). Moreover, early 1900s; reconstruction in Europe and Japan in the the super cycles in the six metals under consideration aftermath of the second world war; and the most recent have strong contemporaneous correlation, except for one driven by rapid industrialisation and urbanisation of aluminium-lead and aluminium-zinc (Table V.2.1). China beginning in the early 2000s (Jerrett, 2021). The super-cycle component of each of these metals, Following Cuddington and Jerrett (2008), the statistical barring aluminium and nickel, peaked around 2014- filtering technique of an asymmetric Christiano and 2016 though they remain above their long-term trend. Chart V.2.1: Commodity Market Developments a: Bloomberg Commodity Index b: Commodity Price Indices (Monthly) Sources: Bloomberg; and World Bank. (Contd.) 2 The ACF BP filter has been applied to the natural logarithm of annual real metal prices of six non-ferrous metals, viz. copper, aluminium, lead, zinc, nickel and tin for the period 1900 to 2021. The annual prices from 1960 onwards are sourced from the World Bank. For prior period, back-casting is done by using the US Geological Survey (USGS) data. For 2021, the average of the monthly real prices (nominal prices deflated by the US CPI) from January to July is considered. 3 Long term trend can also be defined as the actual series minus all the cyclical components with periods between 2 and 70 years (i.e., both super-cycle and other shorter cyclical components) and thus BP (2,70) and BP (70, (cid:102)) can be treated as complements. 9911Monetary Policy Report October 2021 Chart V.2.2: Real Price Components- Base Metals a: Copper b: Aluminium c: Lead d: Zinc e: Nickel f: Tin Sources: World Bank; USGS database; and RBI staff estimates. it is too early to classify the ongoing broad-based price Table V.2.1: Correlations between Super-Cycle escalation as a new commodity super cycle. Components of Real Prices References: Aluminium Copper Lead Tin Nickel Zinc Christiano, L. and T. Fitzgerald, 2003, ‘‘The Band Pass Aluminium 1.00 Filter,’’ International Economic Review, Vol. 44, No. 2, Copper 0.32* 1.00 Lead -0.00 0.74* 1.00 May, pp. 435-465. Tin 0.35* 0.56* 0.73* 1.00 Cuddington, J.T. and D. Jerrett, 2008, “Super Cycles in Nickel 0.81* 0.61* 0.47* 0.50* 1.00 Real Metals Prices?”, IMF Staff Papers, Vol. 55, No. 4, Zinc -0.07 0.67* 0.71* 0.60* 0.26* 1.00 December, pp. 541-565. *: Statistically significant at 1 per cent level. Source: RBI staff estimates. Heap, A., 2005, “China - the Engine of a Commodities Super Cycle,” Equities Research: Global, Citigroup Smith This suggests that commodities might still be in the Barney, March 31. downswing phase of the super cycle that began in early Jerrett, D., 2021, “How Super is the Commodity Cycle?”, 2000s. In contrast, the shorter cycle components for all Global Commodities Applied Research Digest, Summer metals are showing an upturn, likely reflecting supply-side 2021, http://www.jpmcc-gcard.com/digest-uploads/2021- factors such as escalating transport and logistics frictions summer/Page%2074_79%20GCARD%20Summer%20 and costs. Moreover, the recent reversal in prices of some 2021%20Jerrett%20042021.pdf. metals weakens the narrative of a new super cycle. Hence, 9922Chapter V External Environment Prices firmed up across major AEs, pushing inflation seen since the global financial crisis. Fed’s preferred above targets for most of them, barring Japan (Table measure of inflation, the personal consumer V.3). For major EMEs, barring Indonesia and Thailand, expenditures (PCE) inflation, lagged CPI inflation headline inflation has remained close to the upper but was at 30-year high level during July-August due bound of the official target band or beyond, while for to high energy and food prices. The surge in pent- China, inflationary pressures have remained subdued up demand following the re-opening of economy, in terms of consumer prices, notwithstanding strong persistent supply-side constraints and high input costs upside pressures from producer prices. are lending upside to inflation. The Fed attributes the spike in inflation to transitory factors. In the Euro The return of inflation in the US has been stark. area, the inflation rate moved beyond the European CPI inflation hit a 13-year high, reaching levels not Central Bank (ECB)’s target of 2 per cent, surging to a 13-year high of 3.4 per cent in September on rising Table V.3: Inflation (Per cent) energy costs and prices of non-energy industrial goods and services, besides unfavourable base effect. Country Inflation Q3:2020 Q4:2020 Q1:2021 Q2:2021 Q3:2021 Target The ECB too, attributes the recent rise in inflation to (current) transitory factors and expects it to moderate back to Advanced Economies the target once pandemic-induced shocks wane. CPI Canada 2.0 0.2 0.8 1.4 3.4 3.9 Euro area 2.0 0.0 -0.3 1.0 1.8 2.9 inflation in the UK edged up above the target in May- Japan 2.0 0.2 -0.8 -0.5 -0.8 -0.4 June and eased back to the 2 per cent target in July. South Korea 2.0 0.7 0.4 1.1 2.4 2.6 In August, however, the inflation rate soared to 3.2 UK 2.0 0.6 0.5 0.6 2.0 2.6 US 2.0 1.2 1.2 1.8 3.9 4.2 per cent, the highest ever jump in rate, mainly due Emerging Market Economies to an unfavourable base effect. In Japan, unlike its Brazil 3.75 ± 1.5 2.6 4.3 5.3 7.7 9.3 AE counterparts, CPI remained in deflation for the Russia 4.0 3.6 4.4 5.6 6.0 6.6 eleventh consecutive month in August as COVID-19 India 4.0 ± 2.0 6.9 6.4 4.9 5.6 5.4 continued to impact demand, keeping core inflation China - 2.3 0.1 0.0 1.1 0.9 South Africa 3.0-6.0 3.1 3.2 3.1 4.8 4.8 subdued, while a sharp drop in monthly mobile phone Indonesia 3.0 ± 1.0 1.4 1.6 1.4 1.5 1.6 charges added to the downside (Chart V.5a). Philippines 3.0 ± 1.0 2.5 3.1 4.5 4.4 4.6 Thailand 1.0-3.0 -0.7 -0.4 -0.5 2.4 0.7 Among major EMEs, CPI inflation in Brazil has Turkey 5.0 ± 2.0 11.8 13.5 15.6 17.1 19.3 been above the upper bound of the tolerance band Notes: (1) Inflation for US is in terms of personal consumption around the inflation target since February 2021. In expenditure price index. (2) Quarterly inflation is the simple average of inflation in each August, CPI inflation rose to its highest reading since month of the quarter. For Q3:2021, it is the July-August average for all countries except Euro area, South Korea, Indonesia, February 2016, primarily led by a surge in electricity Phillipines, Thailand and Turkey, for which it is full quarter and fuel prices amidst supply disruptions brought average. (3) The ECB adopted new monetary policy strategy from July 8, in by the worst drought witnessed by the country 2021 under which a symmetric 2 per cent inflation would be targeted over the medium term unlike the earlier target of in almost a century. High global commodity prices, “below but close to 2 per cent’. The Bank of Canada aims to the depreciating Brazilian real and reviving demand keep inflation at the 2 per cent mid-point of an inflation control target range of 1-3 per cent. are imparting upward pressure on prices. In Russia, (4) Brazil’s inflation target for 2020 was 4.0 ± 1.5 per cent. Sources: Central bank websites; and Bloomberg. inflation has been above the official target level since 9933Monetary Policy Report October 2021 Chart V.5: CPI Inflation (y-o-y) – Select Economies a: Advanced Economies b: Emerging Market Economies Sources Bloomberg. November 2020, scaling to a five-year high in August V.3 Monetary Policy Stance as rising inflation expectations, recovery in demand Extraordinary policy measures by monetary and and strained supply capacity have kept inflationary fiscal authorities continue to support economies pressures elevated. In South Africa, CPI inflation and ease financial conditions, helping to contain picked up from April due to increase in fuel costs, financial stability risks. The IMF estimates that and high food and beverage prices. In June-July, since March 2020, US$16.5 trillion or about 15.9 however, inflation eased due to softening transport per cent of global GDP had been pledged as fiscal prices and favourable base effect before rising again support in response to the pandemic, with higher in August on high fuel and food prices. China, support extended by AEs vis-à-vis the EMEs on the other hand, remains an outlier with CPI (Table V.4). While most of the fiscal measures in the inflation remaining highly subdued, primarily EMEs had expired in 2020, almost US$4.6 trillion due to decline in food prices as also easing costs worth of measures remain available to AEs as of early of transportation and communication amidst July 2021. weak services sector demand (Chart V.5b). China’s The total monetary support extended globally by producer price index, however, has risen sharply, central banks is estimated to be about US$18.0 pushing factory-gate inflation to its highest level in trillion as of August 20214. This support has been 13 years in August as high raw material costs and predominantly in the form of asset purchases, around persistent disruptions due to global supply shortages US$11.6 trillion, followed by lending operations of exert upward pressure. US$4.4 trillion. 4 These are RBI staff estimates, based on BIS database available on https://www.bis.org/publ/work934.htm. This database is for 39 major economies – 11 AEs and 28 EMEs and numerical estimates for several measures listed are not available. As such the estimate might not fully reflect the policies taken by these central banks in response to COVID-19. 9944Chapter V External Environment initially a temporary facility introduced in end-March Table V.4: Fiscal Support in Response to COVID-19 2020 and extended up to September 2021 – is now (Amount in US$ billion; Per cent as proportion of GDP) a permanent facility. The September Federal Open Country Amount Per cent Market Committee (FOMC) statement noted that if Advanced Economies - 28.7 of which, the progress towards its maximum employment and Canada 326 19.8 inflation goals continued as expected, a moderation in European Union 1,361 10.5 the pace of asset purchases would be warranted soon. Japan 2,260 44.8 UK 893 33.0 The FOMC also doubled the per-counterparty limit for US 5,838 27.9 ON RRP operations to US$160 billion per day, effective Emerging Market Economies - 6.7 of which, September 23, 2021. Brazil 221 15.4 The ECB maintained a hold on its policy rate and Russia 89 6.0 India 232 8.7 the quantum of asset purchases in its meetings in China 903 6.1 April and June. On July 8, the ECB unveiled its new South Africa 30 9.9 monetary policy strategy under which a symmetric World 16,500 15.9 Source: World Economic Outlook Update, July 2021, IMF. 2 per cent inflation target was adopted, as against the earlier target of below but close to 2 per cent. Monetary policy stances have diverged across The Harmonised Index of Consumer Prices (HICP) countries, with a few major AEs and EMEs continuing remains the measure of the price level5 and the to maintain an accommodative stance while others primary monetary policy instrument is the set of have begun/continued with the withdrawal of ECB policy rates. With the policy rates ruling close monetary stimulus. to their effective lower bound, the ECB would likely The US Fed maintained the target range for the resort to other instruments such as forward guidance, federal funds rate at 0 to 0.25 per cent and the asset purchases, longer-term refinancing operations monthly pace of asset purchases at US$120 billion in and other new policy instruments as required. As all its meetings held in Q2 and Q3. In June, the Fed part of the strategy review, the ECB also announced effected a hike of 5 basis points (bps) in the interest a detailed roadmap up to 2024 for its comprehensive rate paid on required and excess reserve balances to action plan on climate change. In its July meeting, the 0.15 per cent. The interest rate on overnight reverse first under the new framework, the ECB maintained repurchase agreement (ON RRP) operations was an accommodative monetary policy stance to meet its also increased by 5 bps to 0.05 per cent. Effective inflation target and provided forward guidance that July 29, the Fed merged the interest rates on excess interest rates would remain at their current level or reserves and required reserves to a single interest lower till the inflation target was durably achieved. rate on reserve balances. The Fed also announced In its September meeting, the ECB announced a two standing lending facilities, both overnight and moderately lower pace of asset purchases under the collateralised, viz., domestic standing repurchase Pandemic Emergency Purchase Programme (PEPP), agreement facility and a repo facility for foreign without reducing the overall quantum of the purchase and international monetary authorities. The latter – programme that is scheduled to end by March 2022. 5 As a multi-year project, the EU's statistical agency – Eurostat – will lead a project to include costs related to owner-occupied housing in the HICP to better measure the inflation relevant for households. In the interim, the ECB will also consider initial estimates of the cost of owner-occupied housing in conjunction with the other broader inflation measures for monetary policy assessment. 9955Monetary Policy Report October 2021 It has kept purchases under the Asset Purchase Central banks of four AEs, viz., Iceland, Czech Programme (APP) unchanged. Republic, South Korea and Norway have raised their policy rates in 2021 so far. The central bank of Iceland The Bank of England (BoE) maintained a pause on the has effected two hikes of 25 bps each and the Czech bank rate at its all-time low of 0.1 per cent and kept National Bank has raised rates thrice to a cumulative the total quantum of asset purchases unchanged in increase of 125 bps. Bank of Korea and Norges Bank its meetings in May, June, August and September. In its August meeting, the BoE indicated that a modest raised policy rates by 25 bps in August and September, tightening of monetary policy over its three-year respectively (Chart V.6a). forecast period is likely and it signalled that, given Within the EMEs, there has mostly been status quo or appropriate economic circumstances, it would begin a move towards unwinding monetary accommodation, unwinding its quantitative easing by not re-investing though some countries have extended the stimulus maturing assets once the bank rate is raised to 0.5 per also. For instance, the People’s Bank of China (PBoC) cent6. increased the liquidity in the system by lowering the The Bank of Japan (BoJ) in its meetings in April, reserve requirement for most financial institutions June, July and September kept the monetary policy by 50 bps effective July 15, freeing up about 1 trillion parameters – the key policy rates and the quantum of yuan (approximately US$154.3 billion) of liquidity to asset purchases – unchanged. In July, the BoJ sketched support the real economy. The PBoC has, however, the preliminary outline of the Fund-Provisioning maintained the one-year Loan Prime Rate (LPR) at 3.85 Measure to Support Efforts on Climate Change. The per cent since April 2020. new measure would come into effect in 2021 under Amongst other BRICS central banks, Banco Central do which the BoJ would provide interest-free loans Brasil followed up on its 75 bps rate action of March against collateral for up to one year, with possibility with equal hikes of 75 bps each in May and June and of rollover, for on-lending to projects that address 100 bps each in August and September. The Bank of climate change7. Moreover, banks would be allowed Russia followed up on its 25 bps rate hike of March to add twice the amount of any borrowing under the with hikes of 50 bps each in April and June, 100 bps scheme to their macro add-on balances, which would in July and 25 bps in September. The South African earn 0 per cent interest as against the policy rate, Reserve Bank maintained a pause in its May, July and which is currently (-) 0.1 per cent. September meetings. The Bank of Canada (BoC) maintained its policy rate and the forward guidance in its meetings in The central bank of Turkey, which had maintained April, June, July and September but effected tapers status quo since a hike of 200 bps in March 2021, of CAD$1 billion (approximately US$0.8 billion)8 in cut rates by 100 bps in September attributing high its weekly purchases of government bonds in the inflation to transitory factors and noting that April and July meetings, reducing the weekly pace monetary tightening had lowered credit and domestic of asset purchases to CAD$2 billion (approximately demand. Amongst other EME central banks, Banco US$1.6 billion). de México hiked rates by 25 bps each in June, August 6 The previous guidance of June 2018 had set a higher threshold of 1.5 per cent. 7 Green loans/bonds, sustainability-linked loans/bonds with performance targets related to efforts on climate change and transition finance. 8 The US$ approximations for all amounts mentioned in another currency in this Chapter are based on the exchange rate (Bloomberg) on the date of announcement of the measure. 9966Chapter V External Environment Chart V.6: Policy Rate Changes – Select Economies a: Advanced Economies b: Emerging Market Economies Source: Bloomberg. and September, while the Central Bank of Chile raised seven consecutive months of gains up to August – the rates by 25 bps in July and 75 bps in August (Chart longest rally since the end of the sovereign debt crisis V.6b). The central banks of Peru and Hungary have in 2012 – which came to an end in September. Strong also raised rates in recent months. corporate earnings and the accommodative monetary policy stance of the ECB had helped keep the markets V.4 Global Financial Markets bullish. The UK stock indices rose during Q2 due to Global financial markets remained buoyant and easy the rapid pace of vaccination, attractive valuations financing conditions prevailed; however, volatility and high dividend yield but have been flat thereafter. returned to the markets in September. Stock markets The Nikkei, which was trending down since Q2 as in a few AEs and EMEs scaled fresh peaks in September Japan lagged the other three major AEs in its pace of but slid in most countries. Bond yields, which had vaccination and infection control, rose from the last remained low up to August, edged up in September week of August due to election fever and increased due to large sell-offs. The US dollar rallied in the wake pace of vaccination overtaking the US. of higher inflation and inflation expectations and EME stock indices had been essaying the fault lines the Fed announcement on commencement of the US in global recovery, and trending down since June due taper in the near future. The EME financial markets, to the two-speed nature of the recovery, moderation unlike 2013, did not experience a major upheaval in of capital flows and rapid spread of the delta variant Q3 despite taper guidance by the Fed. of the virus (Chart V.7). The EME stock markets got Among AEs, the US equity markets continued to scale buffeted in August with China’s regulatory crackdown a new peak every month in Q2 and Q3, even after the and continued to fall in September on concerns Fed indication of likely taper. After peaking in early- relating to China and change in monetary policy September, the US market fell, led by technology stocks, stance of several AEs. Stock markets in EMEs such as and recorded its first monthly decline since January. India and Russia, however, notched all-time highs in Among other major AEs, European stock markets had September. 9977Monetary Policy Report October 2021 Chart V.7: Equity Markets a. Equity Indices (MSCI) b. Changes in Equity Indices Source: Bloomberg; and RBI staff estimates. Bond yields in major AEs trended down in Q2:2021 and BoE, bond yields shot up sharply in most AEs and remained range-bound in Q3 up to August, led by large sell-offs. In the US, long-term treasury reflecting the accommodative monetary policy yields, which had risen at a rapid clip in Q1:2021 stance maintained by the Fed, the ECB and the BoJ. in line with rise in inflation expectations, treaded Also, due to the persistent threat to recovery with down in April-July even as inflation and inflation rapid spread of the delta variant, the safe haven expectations remained high (Chart V.8a). In August, demand for government bonds continued. Since however, movements in long-term yields were the September monetary policy meetings of the Fed more range-bound. Despite the significant rise in Chart V.8: Bond Yields a: 10-year Sovereign Bond Yields in Select AEs b: 10-year Sovereign Bond Yields in Select EMEs Source: Bloomberg. 9988Chapter V External Environment Chart V.9: Currency Movements and Capital Flows a: Currency Indices b: Portfolio Flows to EMEs Source: Bloomberg. September, the 10-year yield at end-September forecast in March. Nevertheless, overall capital flows was 25 bps lower than that prevailing at end-March in September were higher than in August due to large 2021. sovereign bond issuances by EMEs (Chart V.9b). The MSCI Emerging Market Currency Index increased by Yields in the EMEs moved bi-directionally till August 2.2 per cent in Q2:2021 but declined by 0.9 per cent – rising in those countries that began normalising in Q3:2021. monetary policy, while remaining soft in those with continued central bank support. EME bond yields V.5 Conclusion rose in September, in line with the global trend The multi-speed economic recovery across countries (Chart V.8b). is becoming increasingly susceptible to renewed In currency markets, the US dollar has been bouts of rapid spread of infections. There has been a strengthening since June 2021 on better economic perceptible slowdown of economic activity across the prospects for the US as also higher inflation outcomes. globe in recent months, particularly in Asia. Inflation The dollar rally strengthened in September in remains high across the world, with supply disruptions expectation of commencement of US taper later in becoming more widespread. There is a risk that above 2021. In contrast, the emerging market currencies target inflation may persist longer than anticipated have depreciated after peaking in the second week in several economies. The pervading threat of the of June (Chart V.9a). This was mainly triggered by delta variant has led monetary authorities – that had retrenchment of capital flows following the release earlier signalled unwinding – to be on hold, while of the FOMC statement where dot plots suggested incremental inflationary pressures have made others two likely rate rises in 2023 as against no rate hike signal a sooner unwinding. 9999