RESERVE BANK OF INDIA

Second Quarter Review ofMonetary Policy 2009 -10

October 27, 2009Mumbai

Dr. D. SubbaraoGovernor

(Including Review of Developmental and Regulatory Policies)

CONTENTS

Page No.

Part A: Monetary Policy

I. Macroeconomic and Monetary Developments ........................................ 2

II. Stance of Monetary Policy ...................................................................... 22

III. Monetary Measures ................................................................................. 29

Part B: Developmental and Regulatory Policies

I. Financial Stability ................................................................................... 31

II. Interest Rate Policy ................................................................................. 32

III. Financial Markets .................................................................................... 32

IV. Credit Delivery Mechanism and Other Banking Services ..................... 36

V. Financial Inclusion .................................................................................. 40

VI. Regulatory Measures for Commercial Banks ........................................ 43

VII. Institutional Developments ..................................................................... 47

ACRONYMS

ADRs - American Depository Receipts

AFCs - Asset Finance Companies

AFS - Available for Sale

ALM - Asset Liability Management

ARR - Automated Regulatory Reporting

ASP - Application Service Provider

ATM - Automated Teller Machine

BC - Business Correspondent

BCBS - Basel Committee on Banking Supervision

BE - Budget Estimates

BEI - Business Expectation Index

BPL - Below Poverty Line

BPLRs - Benchmark Prime Lending Rates

BSE - The Stock Exchange, Mumbai

CARE - Credit Analysis and Research Limited

CBLO - Collateralised Borrowing and Lending Obligation

CBS - Core Banking Solution

CCF - Credit Conversion Factor

CCIL - Clearing Corporation of India Limited

CDs - Certificates of Deposit

CDS - Credit Default Swap

CGFTMSE - Credit Guarantee Fund Trust for Micro and Small Enterprises

CI - Confidence Interval

CIS - Commonwealth of Independent States

CP - Commercial Paper

CPI - Consumer Price Index

CPI-IW - Consumer Price Index for Industrial Workers

CPI-UNME - Consumer Price Index for Urban Non-Manual Employees

CRAR - Credit to Risk-Weighted Assets Ratio

CRISIL - Credit Rating Information Services of India Limited

CSO - Central Statistical Organisation

CTS - Cheque Truncation System

DCC - District Consultative Committee

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DGA - Duration Gap Analysis

DICGC - Deposit Insurance and Credit Guarantee Corporation

DTL - Demand and Time Liabilities

DvP - Delivery versus Payment

EBT - Electronic Benefit Transfer

ECAIs - External Credit Assessment Institutions

ECBs - External Commercial Borrowings

ECR - Export Credit Refinance

EMEs - Emerging Market Economies

EXIM Bank - Export-Import Bank of India

FAO - Food and Agriculture Organisation

FCCBs - Foreign Currency Convertible Bonds

FDI - Foreign Direct Investment

FICCI - Federation of Indian Chambers of Commerce & Industry

FIIs - Foreign Institutional Investors

FSB - Financial Stability Board

FSU - Financial Stability Unit

G-20 - Group of Twenty

GBP - Great Britain Pound

GDP - Gross Domestic Product

GDRs - Global Depository Receipts

GFSR - Global Financial Stability Report

GSDP - Gross State Domestic Product

HFCs - Housing Finance Companies

HFT - Held for Trade

HLCCFM - High Level Coordination Committee on Financial Markets

HSBC - Hongkong and Shanghai Banking Corporation

HTM - Held to Maturity

IBA - Indian Banks' Association

ICCL - Indian Clearing Corporation Limited

ICT - Information and Communication Technology

IDBI SASF - Industrial Development Bank of India Stressed AssetStabilisation Fund

IDRBT - Institute for Development and Research in Banking Technology

IIP - Index of Industrial Production

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IMF - International Monetary Fund

INR - Indian Rupee

IOSCO - International Organisation of Securities Commissions

IRFs - Interest Rate Futures

IT - Information Technology

LABs - Local Area Banks

LAF - Liquidity Adjustment Facility

LIC - Life Insurance Corporation

M3 - Broad Money

MFIs - Micro-Finance Institutions

MFs - Mutual Funds

MICR - Magnetic Ink Character Recognition

MIS - Management Information System

MoU - Memorandum of Understanding

MSEs - Micro and Small Enterprises

MSS - Market Stabilisation Scheme

NABARD - National Bank for Agriculture and Rural Development

NBFCs - Non-Banking Financial Companies

NBFCs-ND-SI - Systemically Important Non-Deposit Taking NBFCs

NCAER - National Council for Applied Economic Research

NCDs - Non-Convertible Debentures

NDS - Negotiated Dealing System

NDTL - Net Demand and Time Liabilities

NECS - National Electronic Clearing Service

NEFT - National Electronic Funds Transfer

NHB - National Housing Bank

NIMC - National Implementing and Monitoring Committee

NPAs - Non-Performing Assets

NREGA - National Rural Employment Guarantee Act

NSCCL - National Securities Clearing Corporation Limited

NSE - National Stock Exchange

NSM - Note Sorting Machines

OECD - Organisation for Economic Co-operation and Development

OMO - Open Market Operation

OTC - Over-the-Counter

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OTS - One-Time Settlement

PACS - Primary Agricultural Credit Society

PCO - Public Call Office

POS - Point-of-Sale

PSB - Public Sector Bank

PSLC - Priority Sector Lending Certificate

Q - Quarterly

RBI - Reserve Bank of India

RE - Revised Estimates

REER - Real Effective Exchange Rate

RM - Reserve Money

RRBs - Regional Rural Banks

RTGS - Real Time Gross Settlement

SCBs - Scheduled Commercial Banks

SDLs - State Development Loans

SDRs - Special Drawing Rights

SEBI - Securities and Exchange Board of India

SHGs - Self-Help Groups

SIDBI - Small Industries Development Bank of India

SLBC - State Level Bankers' Committee

SLR - Statutory Liquidity Ratio

SMEs - Small and Medium Enterprises

SPV - Special Purpose Vehicle

STRIPS - Separate Trading for Registered Interest and Principal ofSecurities

TAC - Technical Advisory Committee

TGA - Traditional Gap Analysis

UCBs - Urban Co-operative Banks

UK - United Kingdom

US - United States of America

WEO - World Economic Outlook

WPI - Wholesale Price Index

Y-o-Y - Year-on-Year

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Reserve Bank of IndiaSecond Quarter Review of Monetary Policy 2009-10

ByDr. D. Subbarao

Governor

The global economy has begun torecover from the deep recession set off bythe financial crisis. This recovery isunderpinned by output expansion inemerging market economies (EMEs),particularly those in Asia. The pace and shapeof recovery, however, remain uncertain.

2. In fact, the global economic outlookpresents a mixed picture. On the positiveside, world output, as per the InternationalMonetary Fund (IMF) estimates, hasexpanded by 3 per cent in the secondquarter (quarter-on-quarter, annualised),manufacturing activity has picked up, tradeis recovering, financial market conditions areimproving, and risk appetite is returning. Asharp recovery in equity markets has enabledbanks to raise capital to repair their balancesheets. In the US, home prices appear to bestabilising. Capital flows to EMEs haveresumed. Most importantly, the anxiety andnervousness that pervaded the financialmarkets during the height of the crisis arebeing replaced by a sense of calm.

3. On the negative side, there areconcerns that the recovery is fragile. Thesecond quarter improvement is essentiallythe outcome of policy-induced stimulus.Going forward, the impact of the stimuluswill fade away and inventory rebuilding maylose momentum. In advanced economies,private consumption remains constrained by

continuing job losses, sluggish incomegrowth and dented confidence. Even asoutput is recovering, unemployment isexpected to increase to over 10 per cent inthe US and the Euro area. Investment is alsoexpected to remain weak due to rupturedbalances sheets, excess capacity andfinancing constraints. Bank collapses arecontinuing. World trade remains below itsyear ago level, notwithstanding recentquarter-on-quarter improvement.

4. Reflecting this mixed trend whichhas a small bias towards the positive, theIMF projected, in its October 2009 WorldEconomic Outlook (WEO), that the rate ofcontraction of the world economy in 2009will be 1.1 per cent, an upward revision fromits projection of a contraction of 1.4 per centmade in its July 2009 WEO. However, theIMF expects the ensuing global recovery tobe slow. In its latest Economic Outlook(September 2009), the Organisation forEconomic Co-operation and Development(OECD) projects the pace of activity toremain weak well into 2010 on account ofnumerous headwinds. On balance, whileglobal economic prospects have improvedsince the First Quarter Review in July 2009,uncertainties remain about the pace andsustainability of economic recovery.

5. The Indian economy, which sloweddown significantly during the second half

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of 2008-09, largely due to the knock-oneffect of the global financial crisis, has begunto stabilise. This is despite the continuingcontraction in exports and the worst droughtsince 1972. Performance of the industrialsector has improved markedly in recentmonths. Both domestic and externalfinancing conditions are on the upturn.Capital inflows have revived. Activity inthe primary capital market has picked upand funding from non-bank domesticsources has eased. Liquidity conditionshave remained easy and interest rates havesoftened in the money and credit markets.

6. At the same time, there are severalnegative indications. Private consumptiondemand is yet to pick up. Agriculturalproduction is expected to decline due tolower Kharif foodgrain production.Services sector growth remains belowtrend. Bank credit growth continues to besluggish. There are also clear signs of risinginflation stemming largely from the supplyside, particularly from food prices.

7. This Second Quarter Review ofMonetary Policy for 2009-10 is thus setagainst the backdrop of incipient signs ofrecovery in the global economy and improvingprospects for the domestic economy. TheReview is organised in two parts. PartA covers Monetary Policy and is dividedinto three sections: Section I provides anassessment of the Macroeconomic andMonetary Developments; Section II definesthe Stance of Monetary Policy; and SectionIII sets out Monetary Measures. Part Bcovers the Developmental and RegulatoryPolicies and is organised into seven sections:Financial Stability (Section I), Interest RatePolicy (Section II), Financial Markets(Section III), Credit Delivery Mechanismand other Banking Services (Section IV),Financial Inclusion (Section V), RegulatoryMeasures for Commercial Banks (SectionVI) and Institutional Developments (SectionVII). Part A of this Statement should be readand understood together with the detailedreview in Macroeconomic and MonetaryDevelopments released yesterday.

Global Outlook

Real GDP

8. Global economic performanceimproved during the second quarter of 2009prompting the IMF to reduce the projectedrate of economic contraction in 2009from 1.4 per cent made in July 2009 to 1.1per cent in its latest World EconomicOutlook (WEO) released in early October2009. The IMF has also revised upwards

the projection of global growth for 2010 to3.1 per cent against the earlier projectionof 2.5 per cent in its July Update (Table 1).

9. In the US, the macroeconomicsignals are mixed. Real GDP in Q2 of 2009contracted by 0.7 per cent, a significantimprovement over the contraction of 6.4per cent in Q1 of 2009, largely due topositive contribution from governmentspending. Home prices have shown signsof stabilisation. On the negative side, the

I. Macroeconomic and Monetary Developments

Part A. Monetary Policy

3

unemployment rate rose to 9.8 per cent inSeptember 2009 and is expected to risefurther. Consumer sentiment dipped onapprehensions about the economy, job andincome prospects.

10. Economic indicators in the euroarea continue to be weak. Real GDPcontracted by 4.9 per cent in Q1 and by 4.8per cent in Q2 of 2009. Unemployment roseto 9.6 per cent in August 2009 and retailsales dipped further. Although consumerand business confidence improved inQ3 of 2009, these are yet to move intopositive territory. Real GDP in the UKcontracted by 5.5 per cent in Q2 of 2009and by 5.2 per cent in Q3 of 2009.Unemployment in the UK rose to 7.9per cent in July-August 2009. Real GDP inJapan expanded by 2.3 per cent in Q2 2009after negative growth for almost a year.Though output is stabilising and consumerand business confidence are improving,industrial outlook remains uncertain withbig companies planning to cut capitaloutlays. Overall, OECD’s Composite

Leading Indicators for August 2009 showsigns of recovery in most of the economies,especially in France and Italy.

Inflation

11. Global commodity prices haverebounded ahead of global recovery. TheFood and Agriculture Organisation (FAO)Food Price Index rose in August-September2009. Along with volatile food prices,industrial metal and gold prices have firmedup in Q3 of 2009. Gold prices have reachedrecord levels on account of significantweakening of the US dollar during thequarter. Crude oil prices have been steadywith a firm undertone during the quarterreflecting the balance of expectations of aneconomic recovery and higher oilconsumption in the future against weakcurrent demand and high inventories.Despite these trends, consumer priceinflation in most developed and emergingmarket economies (other than India) remainsnegative/low due mostly to large outputgaps. The WEO of October 2009 projectsconsumer price inflation in advancedcountries to remain low, rising from 0.1per cent in 2009 to 1.1 per cent in 2010.Consumer price inflation in emerging anddeveloping economies is projected to declinefrom 5.5 per cent in 2009 to 4.9 per cent in2010. In sharp contrast, in India, CPIinflation has not only remained elevated, buthas indeed hardened in recent monthsreflecting higher food prices (Table 2).

Financial Markets

12. The wide array of supportive centralbank actions and pronouncements haveaided in the easing of money markets andthe narrowing of corporate bond spreads.

Table 1: Projected Global GDPGrowth (%)

Country/Region 2009 2010

US (-) 2.7 1.5

UK (-) 4.4 0.9

Euro Area (-) 4.2 0.3

Japan (-) 5.4 1.7

China 8.5 9.0

India 5.4 6.4

Emerging andDevelopingEconomies 1.7 5.1

World (-) 1.1 3.1

Source: World Economic Outlook, IMF, October2009.

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

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Share prices have rebounded in all majormarkets. Most major banks in the US andEurope have reported profits recently afterthe large losses incurred during 2008. Onthe negative side, credit offtake has fallen in2009 in a number of advanced economiesas corporates reduced debt levels in anenvironment of tighter credit standards bylenders. There are concerns, as highlightedby the Global Financial Stability Report(GFSR) of the IMF, that the transfer offinancial risks to fiscal authorities couldcrowd out the private sector and underminethe sustainability of public sector finances.

Monetary Policy Measures

13. Central banks in all the majordeveloped economies, barring Australia,continued with easy monetary policy andhave held policy rates steady in recentmonths. They have also continued withmeasures to provide liquidity and other

support to alleviate stress in the financialmarkets following the crisis. In the currentcycle, the Reserve Bank of Australia hasbeen the first G-20 central bank to raise itspolicy rate (Cash Rate) by 25 basis pointsto 3.25 per cent on October 6 on the backof diminished risk of serious economiccontraction. The Reserve Bank of NewZealand has withdrawn some temporaryemergency liquidity facilities put in placeduring the financial crisis of 2008.

Emerging Market Economies

14. In its October WEO, the IMFprojects the real GDP growth of emergingand developing economies to decelerate to1.7 per cent in 2009 (1.5 per cent projectedin the July Update) from 6.0 per cent in 2008,before rebounding to 5.1 per cent in 2010.The IMF does not expect the rebound to beevenly spread across the EMEs; there willbe a divergence between Asian andnon-Asian EMEs as the rebound would bedriven by China, India and other emergingAsian economies. Emerging markets thathad little direct exposure to the financialmeltdown have displayed significanteconomic momentum in Q3 of 2009, albeitslower than the rapid pace of Q2. China’sexport volumes have been growing,including recently to the US and Europe,leading to improvement in China’s tradesurplus. Growth in industrial production andfixed asset investment in China is estimatedto have improved and its longer-termprospects have remained strong. In contrast,Latin America, Eastern Europe andCommonwealth of Independent States (CIS)are all expected to face contraction in 2009and sluggish growth in 2010, while theMiddle East is projected to grow moderately.

Table 2: Cross-country CPI Inflation:Year-on-Year (%)

CountrySeptember March September

2008 2009 2009

US 4.9 (-) 0.4 (-) 1.3

UK 5.2 2.9 1.1

Euro Area 3.6 0.6 (-) 0.3

Australia 5.0 2.5 1.5 @

Japan 2.1 (-) 0.3 (-) 2.2 #

China 4.6 (-) 1.2 (-) 0.8 #

India* 9.8 8.0 11.7 #

Korea 5.1 3.9 2.2

Brazil 6.3 5.6 4.3

Russia 15.0 14.0 10.7

* CPI for industrial workers. @ June 2009.# August 2009.

Source: Official websites of respective countries andBloomberg.

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Domestic Outlook

15. The Indian economy posted agrowth of 6.1 per cent for Q1 of 2009-10.This is higher than the expansion of 5.8per cent in Q4 of 2008-09, but lower thanthe expansion of 7.8 per cent in thecorresponding first quarter of 2008-09. Theyear-on-year (y-o-y) deceleration in growthwas broad-based covering all the threemajor sectors, viz., agriculture, industry andservices (Table 3).

Agriculture

16. The south-west monsoon rainfallthis year (June 1- September 30) was 23per cent lower than the long-period average,the weakest since 1972. Twenty three of the36 meteorological sub-divisions recordeddeficient rainfall. The entire central andnorthern India received deficient rainfall.The Reserve Bank’s production-weightedrainfall index for 2009 was 73, significantlylower than the index number 104 for 2008.According to the latest information ofprogress of Kharif sowing, the acreageunder paddy declined by 15.7 per cent andthat under oilseeds by 5.2 per cent.

17. The share of agriculture in GDP hasbeen declining over time, and as of 2008-09,

it was 17.0 per cent. However, experienceshows that a deficient rainfall can have adisproportionate impact on overalleconomic prospects and on the sense ofwell-being. Poor output will push up pricesand depress rural labour incomes. Given theinter-sectoral supply-demand linkages, theknock-on impact on the industrial andservices sectors can also be significant. Thelarge stock of foodgrains of 44.3 milliontonnes with public agencies, improvedsupply management, and the social safetynet programmes could mitigate the adverseeffects to an extent.

Industry

18. The industrial sector has shownclear signs of revival in recent months. Theindex of industrial production (IIP)increased at a higher rate of 5.8 per centduring April-August 2009 as comparedwith a growth of 4.8 per cent in thecorresponding period of the previous yearand 0.6 per cent growth in the second halfof 2008-09. While the basic, intermediateand consumer durable goods sectorswitnessed higher growth, the performanceof the capital goods and consumernon-durable sectors was relatively modest.The core infrastructure sector, with a

Table 3: Real GDP Growth (%)

Financial Year Quarterly Growth Rates (y-o-y)

2007-08 2008-09 2008-09 2009-10

Q1 Q4 Q1

Agriculture 4.9 1.6 3.0 2.7 2.4

Industry 7.4 2.6 5.1 (-) 0.5 4.2

Services 10.8 9.4 10.0 8.4 7.7

Overall GDP 9.0 6.7 7.8 5.8 6.1

Source: Central Statistical Organisation (CSO).

Sector

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weight of 26.7 per cent in the IIP, posted agrowth of 4.8 per cent during April-August2009, up from 3.3 per cent in thecorresponding period of the previous year.The leading indicators of industrialproduction, both quanti tat ive andqualitative, also point to revival ofindustrial activity in the months ahead.

Services

19. The performance of the servicessector during April-July 2009 continued tofollow the pattern witnessed in Q4 of2008-09. Trade-related services such ascargo handled at major sea and airportscontinued to show deceleration/negativegrowth reflecting contraction of trade. Thenumber of passengers handled atinternational terminals increased, albeitmarginally, while the number of passengershandled at domestic terminals declined.Other domestic activity related servicessuch as communication and constructionhave begun to show signs of upturn. The

railway revenue-earning freight trafficrecorded good growth.

Demand Components of GDP

20. Continuing the trend witnessedsince Q2 of 2008-09, the two majorcomponents of demand, viz., private finalconsumption expenditure and gross fixedcapital formation (with a combined weightof around 88 per cent) decelerated further inQ1 of 2009-10. Government consumption,which had increased sharply in Q3 and Q4of 2008-09 due to the fiscal stimulusmeasures and the Sixth Pay Commissionpayouts, also decelerated in Q1 of 2009-10.While the direct impact of fiscal stimulus iswaning, its indirect impact on privateconsumption and investment will persist forsome more time. External demandcontinues to remain weak, whereas netexports turned positive in Q1 of 2009-10because of a sharper decline in importsthan in exports as compared with Q1 of2008-09 (Table 4).

Item

Table 4: Demand Components of GDP

Financial Year Q1 Q4 Q1

2007-08 2008-09 2008-09 2009-10

Year-on-Year Growth Rate (%)

Private Final Consumption Expenditure 8.5 2.9 4.5 2.7 1.6

Government Final Consumption Expenditure 7.4 20.2 (-) 0.2 21.5 10.2

Gross Fixed Capital Formation 12.9 8.2 9.2 6.4 4.2

Net Exports (-) 36.7 (-) 41.2 (-) 75.9 (-) 30.8 231.8

Share in GDP (%)

Private Final Consumption Expenditure 57.2 55.5 58.0 51.4 55.6

Government Final Consumption Expenditure 9.8 11.1 9.6 13.4 9.9

Gross Fixed Capital Formation 31.6 32.2 32.2 31.6 31.6

Net Exports (-) 4.3 (-) 5.8 (-) 1.3 (-) 2.9 1.6

Source: Central Statistical Organisation (CSO).

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Corporate Performance

21. Sales of the private non-financialcorporate sector declined marginally(0.9 per cent) in Q1 of 2009-10 on ayear-on-year basis as also in comparisonwith Q4 of 2008-09 (1.7 per cent). In thewake of the downturn, firms respondedquickly to the changed cyclical conditionsby reducing their inventories around Q2of 2008-09. Now, with the onset of recoveryin Q1 of 2009-10, the upturn is characterisedby an increase in the stocks to sales ratio.Year-on-year growth in net profits alsowitnessed a turnaround in Q1 of 2009-10after registering negative growth in thepreceding three quarters (Table 5).

Business Confidence

22. The Reserve Bank has beenconducting a quarterly Industrial OutlookSurvey of manufacturing companies since1998. The survey tracks businessexpectations for the current quarter andbusiness outlook for the following quarter.

The latest round of the survey conductedduring July-August 2009 showed aturnaround in the business sentiment. Theassessment for Q2 of 2009-10 showedcontinuing upturn with a 7.8 per centincrease in the Business Expectations Index(BEI) over the previous quarter.Considerable improvement was noted in keyindicators such as production, order booksand capacity utilisation. The financingconditions were also reported to be better.

23. The outlook of manufacturingcompanies for Q3 of 2009-10 maintains itsupward trend, with the BEI moving up to116.4 from 109.9 in the previous quarter.The respondents expect production andcapacity utilisation to improve further,working capital finance requirement togrow, the cost of raw materials to rise andpricing power to return to them. On the backof improved demand conditions, themanufacturing companies also expectfurther improvement in their employmentsituation. The findings of the Reserve

Item

Table 5: Performance of the Private Corporate Sector

Full Year Q1 Q4 Q1

2007-08 2008-09 2008-09 2009-10

Growth Rate (%)

Sales 18.6 17.2 29.3 1.9 (-) 0.9

Expenditure 19.4 19.5 33.5 (-) 0.5 (-) 4.4

Consumption of Raw Materials 18.4 18.5 36.1 (-) 7.4 (-) 13.4

Staff Cost 22.4 19.5 23.2 11.0 8.2

Gross Profits 24.9 (-) 4.2 11.9 (-) 8.8 5.8

Net Profits 26.0 (-) 18.4 6.9 (-) 19.9 5.5

Ratio (%)

Interest to Sales 2.5 3.1 2.4 3.2 2.8

Gross Profit to Sales 14.9 13.3 14.5 13.7 15.7

Net Profit to Sales 9.8 8.1 9.7 8.1 10.2

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Bank’s Industrial Outlook Survey arebroadly consistent with business confidencesurveys conducted by other agencies suchas FICCI, NCAER, HSBC-Markit and Dunand Bradstreet.

Inflation

24. The headline inflation, asmeasured by year-on-year variations in thewholesale price index (WPI), whichremained negative during June-August2009 due to the base effect, returned topositive territory in September 2009. WPIinflation was 1.21 per cent on October 10,2009 as compared with 11.30 per cent ayear ago, and 0.84 per cent at end-March2009. During the current financial year(up to October 10, 2009), WPI hasincreased by 5.95 per cent reflectinghigher food price inflation aggravated bydeficient monsoon.

25. The upside risk of deficientmonsoon rainfall projected in the FirstQuarter Review of July 2009 has sincematerialised and prices of primary fooditems and manufactured food products haverisen due to short supply. During the currentfinancial year (up to October 10, 2009), the

increases in prices of wheat (3.5 per cent)and rice (5.9 per cent) were relatively lowas supply side pressures were mitigated bythe comfortable levels of foodgrain stockswith public agencies which stood at 44.3million tonnes as on October 1, 2009 asagainst the minimum stock norm of 16.2million tonnes. However, large increaseswere recorded in prices of vegetables (59.3per cent), tea (30.7 per cent), sugar,khandsari and gur (28.7 per cent), egg,meat and fish (25.3 per cent), pulses (19.2per cent), jowar (14.9 per cent), condimentsand spices (14.2 per cent), milk (7.0per cent) and fruits (5.2 per cent).

26. The current inflationary pressures,as WPI moves from negative to positiveterritory, are quite different from theinflationary pressures witnessed in April-October 2008. Although both inflationepisodes are driven by supply sidepressures, the inflation in 2008 wastriggered largely by a sharp increase in theprices of basic metals and mineral oils. Incontrast, during the current episode, pricepressures are emanating from domesticsources reflecting increase in prices of foodarticles and food products (Chart 1).

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27. At a disaggregated level, WPIinflation rates of food articles, essentialcommodities and manufactured foodproducts are currently in double digits andare ruling much above their trend levels(Table 6).

28. The recent contrarian movementsin the WPI and CPI inflation rates haveraised questions about the correlationbetween them. In the short-term, inflationrates based on WPI and CPIs could bedifferent due to differences in coverageand weights. However, these differenceseven out over time as wholesale pricechanges are followed by changes in theretail prices. For example, in the five yearperiod 2003-08, the average inflation basedon consumer price index for industrialworkers (CPI-IW) of 4.83 per cent was not

very different from the average WPIinflation of 4.99 per cent.

29. The first occasion in the recent pastwhen CPI inflation diverged significantlyfrom WPI inflation was in mid-2004. Thedivergence between the two inflation ratespersisted thereafter but remained within arelatively narrow range. However, thedivergence has widened in the recent periodwith WPI inflation turning negative evenas CPI inflation crossed double digits(Chart 2). Several factors account for thisphenomenon. One, food prices, which havehigher weightage (in the range of 46-69per cent) in the CPI measures than in WPI(26 per cent), have risen sharply in therecent period. Two, miscellaneous group(representing services) in various CPIs(weights in the range of 12-24 per cent)

Table 6: Annual Inflation Rate (Y-o-Y) (%)

Wholesale Price Index (WPI) October 11, 2008 October 10, 2009

WPI - All Commodities 11.30 1.21

WPI - Primary Articles 12.56 8.62

WPI - Food Articles 10.17 13.34

WPI - Fuel Group 14.49 (-) 6.80

WPI - Manufactured Products 9.53 1.26

WPI - Manufactured Food Products 8.82 16.06

WPI - Essential Commodities* 8.66 17.82

WPI - Excluding Fuel 10.43 3.48

WPI - Excluding Food Articles and Fuel 10.50 0.96

Consumer Price Indices (CPIs) September 2008 September 2009

CPI - Industrial Workers # 9.02 11.72

CPI - Urban Non-manual Employees # 8.54 12.88

CPI - Agricultural Labourers 10.98 13.19

CPI - Rural Labourers 10.98 12.97

* Essential commodities (weight in WPI: 17.8 per cent) include rice, wheat, jowar, bajra, pulses, potatoes,onions, milk, fish-inland, mutton, chillies (dry), tea, coking coal, kerosene, atta, sugar, gur, salt, hydrogenatedvanaspati, rape & mustard oil, coconut oil, groundnut oil, long cloth/sheeting, dhoties, sarees & voiles,household laundry soap and safety matches.

# Pertains to August.

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have also exhibited significant pricepressures; these services are not includedin WPI. Three, prices of metals, which donot form part of the CPI group, havedeclined sharply, thereby accentuating thedivergence between CPI and WPI inflationrates. Four, while a strong base effectpushed WPI inflation into negative territoryduring June-August 2009, there was no baseeffect in play for CPI inflation.

30. Inflation based on the CPI forindustr ial workers (IW) and urbannon-manual employees (UNME) has alsowitnessed a one-time step-up reflectingsignificant upward revision in imputedprices of rent-free houses emanating from

the Sixth Pay Commission Award.Notwithstanding the current wide divergencebetween the two sets of price indices, CPIinflation tracks the essential commoditiescomponent of WPI inflation quite closelyindicating that current CPI inflation isessentially driven by food prices (Chart 3).

Asset Price Inflation

31. Asset prices have risen sharply inthe recent period. Stock prices have increasedby more than 70 per cent during the currentfinancial year to date. After showing somecorrection in the latter part of 2008 and earlypart of 2009, real estate prices have risensignificantly in major cities. Commodity

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Table 7: Fiscal Position of the Central Government

% of GDP Actual during April-August

2008-09 2009-10 2008-09 2009-10 (RE) (BE) (% of RE) (% of BE)

1. Gross Tax Revenue 11.8 10.9 30.3 26.2

2. Total Expenditure 16.9 17.4 31.0 33.6

3. Fiscal Deficit 6.2* 6.8 35.8 45.5

4. Revenue Deficit 4.6* 4.8 40.6 54.9

5. Primary Deficit 2.6* 3.0 38.1 62.8

* As per provisional accounts released by the Controller General of Accounts.BE – Budget Estimate RE – Revised Estimate

Item

prices in India have also hardened in recentmonths. Reflecting the firm trend in theglobal market, gold prices in India surged,especially after August 2009, and reacheda level of Rs.16,035 per 10 grams onOctober 23, 2009, up from Rs. 15,105 atend-March 2009.

Fiscal Scenario

32. In the first five months of 2009-10(April-August), the revenue deficit of the

Central Government was 54.9 per cent ofthe budget estimate, while the fiscal deficitwas 45.5 per cent (Table 7).

33. As per budget estimates, thecombined net borrowing requirements ofthe Central and State Governments for2009-10 will be 34 per cent higher thanthe already elevated level of actualborrowings during 2008-09 (Table 8).

34. A major challenge for the ReserveBank, as indicated in the First Quarter

Table 8: Borrowings of the Central and State Governments (Rs. crore)

Item2007-08 2008-09 2009-10Actual Actual Budget Estimates

Central Government

Gross Market Borrowings $ 1,88,215 3,18,550 4,91,044

Net Market Borrowings 1,08,998 2,98,536 3,97,957

State Governments

Net Market Borrowings 56,224 1,03,766 1,40,000*

Total Net Market Borrowings 1,65,222 4,02,302 5,37,957

$ Pertain to dated securities and 364-day Treasury Bills.

* Estimated. The State Governments have been allowed to borrow an additional 0.5 per cent of gross statedomestic product (GSDP) as part of the fiscal stimulus package in 2008-09 and another 0.5 per cent ofGSDP in the Union Budget 2009-10, raising their budgeted borrowings in 2009-10 to 4.0 per cent ofGSDP.

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Review of July 2009, has been themanagement of the large governmentmarket borrowing programme in anon-disrupt ive manner. For th ispurpose, the Reserve Bank initiatedseveral measures, some of which wereunconventional. First, the Reserve Bankfront-loaded the borrowing programme for2009-10 as credit offtake by the privatesector is usually low in the first half.Second, MSS securities of the order ofRs.28,000 crore were de-sequestered.Third, the Reserve Bank resorted to activeliquidity management by way ofunwinding of MSS securities and purchaseof securities through pre-announcedcalendar of open market operations(OMO). The unwinding of MSS securitiesthrough redemption was of the order ofRs.42,000 crore during the first half of theyear. Besides, as against the OMOannouncement of an indicative amount ofRs.80,000 crore through the auction route

for the first half of 2009-10, the actualpurchases were Rs.57,487 crore, theshortfall from projection being on accountof easy liquidity conditions. Feedbackfrom the market participants indicates thatthe OMO provided considerable comfort.

35. The Central Government hasalready completed net market borrowingof Rs. 3,19,911 crore (as much as 80.4per cent of the budget estimate) throughdated securities during 2009-10 (up toOctober 26, 2009) (Table 9). In addition, theState Governments also mobilised Rs.58,683crore (net) through the market borrowingprogramme. Because of the front-loadingof the market borrowing programme, netissuances under the Central Governmentborrowing programme in the remainingperiod of 2009-10 will be Rs.62,464 crore(Table 9). Given the current level ofliquidity, it should be possible to completethis borrowing programme smoothly.

Table 9: Central Government Borrowings during 2009-10: Dated Securities

(Rs. crore)

Full Year First half Second Half

Item(Planned) (Actual)

Planned Actual Balance(up to Oct.26, 2009)

Gross Market Borrowings** 4,18,000 2,95,000 1,23,000 30,000 93,000

Less: Repayment 53,136 33,089 19,500 0 19,500

Net Market Borrowings** 3,64,864 2,61,911 1,03,500 30,000 73,500

Less: OMO Purchases 57,487* 57,487 * 0 *

Add: MSS (Net) ** (-) 53,036 (-) 42,000 (-) 11,036 0 (-) 11,036

Net Supply of Fresh Securities 2,54,341 1,62,424 92,464 30,000 62,464

* Rs. 80,000 crore of OMO purchases were planned for the first half of 2009-10. The Reserve Bank wouldconduct open market operations during the second half of the current fiscal year as and when considerednecessary.

** Excluding the amount raised through MSS de-sequestering.

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36. Despite the large governmentborrowing programme, the weightedaverage yield of dated securities issuedunder the Central Government borrowingprogramme in 2009-10 (up to October 26,2009) at 7.14 per cent was lower than theyield of 8.81 per cent averaged for thecorresponding period of the previous year.However, the yield on the 10-yeargovernment securities rose from 7.01per cent at end-March to 7.47 per cent inearly-September 2009 with increasedvolatility. Subsequently, it stabilised around7.35 per cent by mid-October 2009. TheReserve Bank also varied the maturityprofile of debt issuances tailored to marketappetite. The weighted average maturity ofsecurities issued during 2009-10 (up toOctober 26, 2009) was 11.0 years ascompared with the average maturity of 15.5years in the corresponding period of theprevious year. Market participants indicatethat had there not been active liquidity andmaturity profile management by theReserve Bank, the yield perhaps wouldhave been significantly higher.

Monetary Conditions

37. Growth in monetary aggregatesduring 2009-10 (up to October 9, 2009) hasevolved broadly in line with the projections.The year-on-year growth in reserve money(RM) turned negative reflecting the 400basis points reduction in the cash reserveratio (CRR) of banks during October–January 2008-09, which reduced the banks’balances with the Reserve Bank. Adjustedfor the first round impact of changes inthe CRR, reserve money growth waspositive, but lower than in the previousyear (Table 10).

38. The money supply (M3) growth on

a year-on-year basis at 18.9 per cent as onOctober 9, 2009 remained above theindicative projection of 18.0 per cent setout in the First Quarter Review of July2009. The main source of M

3 expansion was

bank credit to the government reflectinglarge market borrowings of theGovernment. This is in contrast to whathappened in 2008-09, when bank credit tothe commercial sector and net foreign

Table 10: Annual Variations in Monetary Aggregates (%)

Item2008-09 2009-10

(October 10, 2008) (October 9, 2009)

Reserve Money 28.8 (-) 4.0

Reserve Money (adjusted for CRR changes) 20.6 14.3

Currency in Circulation 21.4 15.4

Money Supply (M3) 20.9 18.9

M3 (Policy Projection) 16.5-17.0 * 18.0 **

Money Multiplier 4.44 5.5

Ratio of Net Foreign Exchange Assets of RBI to Currency 210.6 175.9

* Projection as indicated in the Annual Policy Statement 2008-09 (April 2008).

** Projection as indicated in the First Quarter Review of Monetary Policy 2009-10 (July 2009).

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Table 11: Growth in Major Sources of Money Supply as of October (%)

Financial Year Year-on-Year

Item 2008-09 2009-10 2008-09 2009-10(October 10) (October 9) (October 10) (October 9)

Money Supply (M3) 7.7 8.0 20.9 18.9

Net Bank Credit to Government 10.1 12.4 16.8 44.9

Bank Credit to Commercial Sector 9.8 4.1 27.4 10.7

Net Foreign Exchange Assets of the Banking Sector 4.2 (-) 1.4 30.0 (-) 1.2

exchange assets of the banking sector drovethe expansion of M

3 (Table 11).

39. Monetary management during2009-10 has been informed by thecontinued need to provide liquidity tomitigate the adverse impact of the globalfinancial crisis and to complete the largemarket borrowing programme of theGovernment in a non-disruptive manner.The phenomenon of substitution of foreignassets by domestic assets, which began inthe second half of 2008-09, continuedduring the first two months of the currentyear. This trend, however, reversed afterMay 2009, when capital inflows revived ona net basis. Liquidity conditions haveremained comfortable since mid-November2008. During 2009-10 (up to October 23,2009), the average daily amount absorbedby the Reserve Bank under the LAFwindow was of the order of Rs.1,20,000crore, indicating a large surplus with thebanking system, equivalent to 2.7 per centof the net demand and time liabilities(NDTL).

Financing Conditions

Bank Credit

40. Non-food credit by scheduledcommercial banks (SCBs) decelerated

significantly, with the growth rate (y-o-y)falling to 11.2 per cent this year (as onOctober 9, 2009) from 29.4 per cent a yearago. On a financial year basis (up toOctober 9, 2009) too, the growth inscheduled commercial banks’ non-foodcredit at 4.3 per cent is significantly lowerthan the growth of 10.5 per cent in thecorresponding period of last year.

41. Several factors have contributed tothe slowdown in non-food bank credit. One,overall credit demand from themanufacturing sector slowed downreflecting a decline in commodity pricesand drawdown of inventories. Two,corporates were able to access non-bankdomestic sources of funds and externalfinancing – which had almost dried upduring the crisis – at lower costs. Three,unlike in the previous year, oil marketingcompanies reduced their borrowings fromthe banking sector as oil prices moderated.Four, a significant amount of bank financehas gone to the corporate sector throughbanks’ investment in units of mutual funds.Five, banks have also reined in credit to theretail sector due to the perceived increasedrisk on account of the general slowdown.This credit retrenchment was morepronounced in the case of foreign banks and

15

private banks. This is evident from bankgroup-wise analysis, which shows thatcredit from private banks slowed downsharply, while that from foreign banksactually contracted (Table 12). Thus, despiteample liquidity in the system, non-foodbank credit expansion slowed down.

42. Banks used the ample liquidityavailable with them to make largeinvestments in government securities andalso fairly sizeable investments (of theorder of Rs.92,000 crore during the currentfinancial year so far) in units of mutualfunds. Consequently, commercial banks’investments in SLR securities (includingsecurities acquired under the LAF)increased to 30.4 per cent of their NDTL ason October 9, 2009, up from 25.7 per cent ayear ago. Net of LAF collateral securities,banks’ SLR investments were at 27.6per cent of NDTL as on October 9, 2009.

43. As per data at a disaggregated leveldrawn from 49 banks accounting for 95

per cent of total bank credit, the year-on-yeargrowth in bank credit to industry as ofAugust 2009 was lower than that in theprevious year. While the credit flow toagriculture, real estate and NBFCs remainedhigh, it was lower for housing (Table 13).

Total Flow of Financial Resources to theCommercial Sector

44. During the peak of the crisis (ThirdQuarter Review of January, 2009), it wasnoted that the flow of resources to thecommercial sector from both bank andnon-bank sources had contracted. Whilebank credit continues to decelerate asindicated earlier, there has been aturnaround in financing from non-banksources. The resource flow from non-banksources increased in Q2 of 2009-10 withincrease in foreign direct investment,pick-up in primary issues, increased supportfrom insurance companies, and largeinvestment by mutual funds in non-gilt debtinstruments. While the resource flow from

Table 12: Bank Group-wise Deposits and CreditGrowth (Y-o-Y) as of October (%)

Bank Group2008-09 2009-10

(October 10, 2008) (October 9, 2009)

Deposits

Public Sector Banks 23.6 24.4Foreign Bank Group 23.2 11.5Private Bank Group 14.1 6.1Scheduled Commercial Banks* 21.5 20.0

Credit

Public Sector Banks 32.7 15.3Foreign Bank Group 32.9 (-) 15.9Private Bank Group 19.7 2.5Scheduled Commercial Banks* 29.5 10.8

* Including RRBs.

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Table 13: Annual Sectoral Flow of Credit

Sector

As on August 29, 2008 (y-o-y) As on August 28, 2009 (y-o-y)

Amount % share Variations Amount % share Variations(Rs.crore) in total (%) (Rs.crore) in total (%)

Agriculture 41,185 8.5 18.6 67,228 21.8 25.6

Industry 2,30,229 47.5 32.9 1,66,121 53.8 17.9

of which:Micro and Small 23,865 4.9 20.1 40,146 13.0 28.1

Real Estate 20,580 4.2 43.1 28,353 9.2 41.5

Housing 29,872 6.2 12.4 14,668 4.8 5.4

NBFCs 26,443 5.5 51.8 23,837 7.7 30.8

Overall Credit 4,84,805 100.0 26.5 3,08,718 100.0 13.3

Note: Data are provisional and relate to select banks which cover 95 per cent of total non-food credit extendedby all scheduled commercial banks.

the non-bank sources was marginally higherin 2009-10 (up to October 9), the total flowof financial resources to the commercialsector declined in comparison with thecorresponding period of 2008-09 due toslowdown in bank credit (Table 14).

Interest Rates

45. In response to the crisis, theReserve Bank has effected a substantialreduction in policy rates beginning October

2008: the repo rate by 425 basis points andthe reverse repo rate by 275 basis points.The CRR was also reduced by 400 basispoints of NDTL of banks (Table 15).

46. Taking cues from the reduction inthe Reserve Bank’s policy rates and easyliquidity conditions, all public sector banksand most private sector banks have reducedtheir deposit and lending rates. Thereduction in the term deposit rates betweenOctober 2008 and October 1, 2009 has been

Table 14: Total Flow of Financial Resources to the Commercial Sector (Rs.crore)

ItemFull Year Financial Year so far

(up to October 9)

2007-08 2008-09 2008-09 2009-10

From Banks 4,44,807 4,21,091 2,40,092 1,07,861

From Other Sources* 5,64,558 4,68,567 2,28,119 2,30,130

Total Resources 10,09,365 8,89,658 4,68,211 3,37,991

Memo Item:

Mutual Funds Investment inDebt (non-Gilt) Instruments 88,457 (-) 32,168 19,896 1,01,956

* Includes borrowings from financial institutions (including LIC) and NBFCs as well as resources mobilisedfrom the capital market and by way of ECBs, FCCBs, ADRs/GDRs, FDI and short-term credit as per thelatest available data, adjusted for double counting.

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Table 15: Monetary Easing by theReserve Bank since October 2008

As on (%)

Early OctoberOctober 2009 2008

Repo Rate 9.00 4.75 425

Reverse Repo Rate 6.00 3.25 275

Cash Reserve Ratio(% of NDTL) 9.00 5.00 400

Reduction(basis

points)

in the range of 175-350 basis points bypublic sector banks, 100-375 basis pointsby private sector banks and 125-300 basispoints by five major foreign banks. The

reduction in the range of BPLRs was125-275 basis points by public sectorbanks, followed by 100-125 basis pointsby private banks and 125 basis points byfive major foreign banks (Table 16).

Financial Markets

Money and G-Sec Markets

47. As a result of the monetary easingand policy rate reductions beginningSeptember 2008, interest rates havedeclined across the term structure in thedomestic financial markets. The call money

Item

Variation as onOctober 15, 2009

(basis points)

Table 16: Movements in Deposit and Lending Rates(Per cent)

Interest Rates October March April 20, October 15,2008 2009 2009 2009(%) (%) (%) (%)

Over OverOctober April 20,

2008 2009

Term Deposit Rates

Public Sector Banks

a) Up to 1 year 2.75-10.25 2.75-8.25 2.75-8.00 1.00-6.75 175-350 125-175

b) 1 year up to 3 years 9.50-10.75 8.00 -9.25 7.00-8.75 6.25-7.50 325 75-125

c) Over 3 years 8.50-9.75 7.50-9.00 7.25-8.50 6.50-8.00 175-200 50-75

Private Sector Banks

a) Up to 1 year 3.00-10.50 3.00-8.75 3.00-8.50 2.00-7.00 100-350 100-150

b) 1 year up to 3 years 9.00-11.00 7.50-10.25 7.50-9.50 5.25-8.00 300-375 150-225

c) Over 3 years 8.25-11.00 7.50-9.75 7.50-9.25 5.75-8.25 250-275 100-175

Five Major Foreign Banks

a) Up to 1 year 3.50-9.50 2.50-8.00 2.50-8.00 2.25-6.50 125-300 25-150

b) 1 year up to 3 years 3.60-10.00 2.50-8.00 2.50-8.00 2.25-7.50 135-250 25-50

c) Over 3 years 3.60-10.00 2.50-8.00 2.50-8.00 2.25-7.50 135-250 25-50

BPLR

Public Sector Banks 13.75-14.75 11.50-14.00 11.50-13.50 11.00-13.50 125-275 50

Private Sector Banks 13.75-17.75 12.75-16.75 12.50-16.75 12.50-16.75 100-125 0

Five Major Foreign Banks 14.25-16.75 14.25-15.75 14.25-15.75 14.25-15.50 125 25

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rates have remained near or below the lowerbound of the LAF corridor since November2008. Primary yields on Treasury Bills havealso moderated (Table 17).

48. The yield on government securitiesmoved up with increased volatility duringthe early part of the year in the face of alarge borrowing programme of the Centraland State Governments. There was asudden surge in bond yields in late Augustdue to change in market sentiment withthe yield on 10-year Government securitymoving up by 42 basis points duringAugust 13 - September 3, 2009. However,the yield stabilised subsequently on

Table 17: Interest Rates - Monthly Average (%)

Instrument/SegmentOctober March July October

2008 2009 2009 2009*

Call Money 9.90 4.17 3.21 3.18

CBLO 7.73 3.60 2.78 2.51

Market Repo 8.40 3.90 2.81 2.67

Certificates of Deposit (CDs) 10.00 7.53 4.96 3.60

Commercial Papers (CPs) 14.17 9.79 4.71 4.29

91-day Treasury Bills 8.13 4.77 3.22 3.23

10-year Govt. Security 7.80 6.57 7.00 7.33

Modal BPLR of PSBs 14.00 12.50 12.00 12.00

* Average up to October 23, 2009.

assurances by the Reserve Bank that it wouldmanage liquidity conditions and marketborrowing programme of the Governmentin a non-disruptive manner (Chart 4).

49. Presently, banks are permitted tohold statutory liquidity ratio (SLR)securities up to 25 per cent of their demandand time liabilities (DTL) in the ‘held tomaturity’ (HTM) category of investments.Recently, there has been some debate onthe need to raise this limit on the groundthat such a relaxation will mitigate theupward pressure on G-Sec yields, andconsequently on the overall interest rateregime. The Reserve Bank considered the

19

advisability of raising the HTM limit. Itmay be recalled that in 2004-05 bankswere allowed to shift SLR securities to theHTM category as a one-time measuresubject to the total SLR securities held inthe HTM category capped at 25 per centof their DTL. This limit was keptunchanged even as the SLR was reducedfrom 25 per cent to 24 per cent inNovember 2008. As the HTM ratio isalready higher than the prescribed SLR, itis not considered desirable to further raisethe HTM ratio.

Transmission Mechanism

50. The changes in the Reserve Bank’spolicy rates were quickly transmitted to themoney and debt markets. However,transmission to the credit market was slowdue to several structural rigidities in thesystem, especially fixed interest rate depositliabilities. As bank deposits, contracted inthe past at high rates, have started to matureand banks have significantly reduced theirterm deposit rates, the transmission of lowerpolicy rates to the credit market hasimproved. In this context, it should berecognised that the movement in the

benchmark prime lending rates (BPLRs)does not fully and accurately reflect thechanges in effective lending rates as nearlytwo-thirds of banks’ lending takes place atsub-BPLR rates. As such, the truemovements in lending rates of banks arebetter captured in the weighted averagelending rates of banks. Rough estimatesshow that the effective average lending ratefor scheduled commercial banks declinedfrom 12.3 per cent in March 2008 to 11.1per cent by March 2009 – the latest periodfor which data are available (Chart 5).Further, data from select banks, as a proxymeasure for effective lending rates, suggestthat weighted average yield on advancesdeclined from 10.6 per cent in March 2009to 10.3 per cent in June 2009.

51. The analysis by the WorkingGroup on BPLR (Chairman: Shri DeepakMohanty), which submitted its Report onOctober 20, 2009, has demonstrated thatthough there was considerable divergencein weighted average lending rates in 2004among the various bank-groups, these havetended to converge in the recent period.The Group has recommended theintroduction of a Base Rate system.

20

Foreign Exchange Market

52. The foreign exchange marketremained orderly during 2009-10 (up toOctober 23, 2009) with the rupee exhibitinga two-way movement against majorcurrencies. During the current financialyear, the rupee appreciated by 9.7 per centagainst the US dollar and 2.6 per centagainst the Japanese yen, whereas itdepreciated by 5.7 per cent against thepound sterling and 3.2 per cent against theeuro (Chart 6). In terms of the realexchange rate, the six-currency trade-based real effective exchange rate (REER)(1993-94=100) moved up from 96.3 at end-March 2009 to 104.2 by October 23, 2009.

Equity Market

53. During the current financial year(up to October 23, 2009), the secondarysegment of the domestic capital market hasremained buoyant. The stock market stageda smart recovery reflecting large net FIIinflows due to the optimistic outlook forthe Indian economy. FIIs made netpurchases of US$ 13.8 billion in 2009-10(up to October 21, 2009) in the Indianequity market as against net sales of US$8.6 billion in the corresponding period of2008-09. The BSE Sensex rose from9,709 at end-March 2009 to 16,811 onOctober 23, 2009, showing an increase of73.1 per cent during 2009-10 to date.

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Table 18: India’s Balance of Payments(US$ billion)

Item Full Year 2008-09 2009-10

2007-08 2008-09 Q1 Q4 Q1

Exports 166.2 175.2 49.1 39.8 38.8Imports 257.8 294.6 80.5 54.4 64.8Trade Balance (-) 91.6 (-) 119.4 (-) 31.4 (-) 14.6 (-) 26.0Invisibles, net 74.6 89.6 22.4 19.3 20.2Current Account Balance (-) 17.0 (-) 29.8 (-) 9.0 4.7 (-) 5.8Net Capital Account 108.0 9.1 11.1 (-) 5.3 6.7Overall Balance # 92.2 (-) 20.1 2.2 0.3 0.1

Memo:

As percentage of GDPTrade Balance (-) 7.8 (-) 10.3Current Account Balance (-) 1.5 (-) 2.6Net Capital Inflows 9.2 0.8

# Overall balance includes current account balance, net capital account and errors and omissions.

External Sector

54. India’s external account hasremained comfortable during the currentfinancial year. Merchandise trade contracteddue to depressed external demand andslowdown of the domestic economy, withimports declining more than exports. Thetrade deficit narrowed down to US$ 26.0billion in Q1 of 2009-10 from US$ 31.4billion in Q1 of 2008-09. However, tradedeficit in Q1 of 2009-10 was higher thanUS$ 14.6 billion in Q4 of 2008-09 partlydue to a rise in crude oil prices (Table 18).The current account deficit at US$ 5.8billion in Q1 of 2009-10 was also lowercompared to the deficit of US$ 9.0 billionin Q1 of 2008-09; a current account surplusof US$ 4.7 billion was recorded in Q4 of2008-09. The capital account showed aturnaround from a negative balance in thelast two quarters of 2008-09 to a positivebalance of US$ 6.7 billion during Q1 of2009-10.

55. In 2009-10 to date, foreign exchangereserves have increased by US$ 32.9 billion,including allocation of SDRs (US$ 5.2billion) by the IMF, and were at US$ 284.8billion as on October 16, 2009 (Table 19).

56. The management of foreignexchange reserves is guided by the changingcomposition of the balance of payments andendeavours to reflect the ‘liquidity risks’associated with different types of flows.

Table 19: Variation in ForeignExchange Reserves

Period Variation (US$ billion)

Full Year

2004-05 28.62005-06 10.12006-07 47.62007-08 110.52008-09 (-) 57.7

Financial Year (up to October 16)

2008-09 (-) 35.82009-10 32.9

22

57. As a part of the accommodativemonetary policy followed since mid-September 2008, the Reserve Bank hasprovided ample rupee and dollar liquidityand maintained a market environmentconducive for the continued flow of creditto productive sectors at lower cost. Theimportant measures initiated includereduction of the policy rates under the LAFto their historically low levels, loweringof reserve requirements, institution ofsector-specific liquidity facilities and aforex swap facility, relaxation in the ECBguidelines, countercyclical prudentialmeasures of adjustment in risk weights andprovisioning, and conditional specialregulatory treatment for restructuredassets.

Liquidity Impact

58. Consistent with its accommodativemonetary stance, the Reserve Bankexpanded its domestic assets through openmarket operations (OMO) and unwindingof market stabilisation scheme (MSS)securities to provide primary liquidity tosupport the required monetary expansion.Several measures taken by the ReserveBank since mid-September 2008 haveaugmented actual/potential liquidity in thesystem on the aggregate by Rs.5,85,000crore.

59. As a result of the extraordinarymonetary easing by the Reserve Bank, thebanking system has been awash withliquidity since November 2008. This isreflected most prominently in theabsorption under the LAF window of a

daily average of almost Rs.1,20,000 crore.The utilisation of the several refinancefacilities instituted by the Reserve Bank toohas been low, further evidencing the ampleliquidity situation. Interest rates in all themarkets have declined significantly overthe last one year as detailed before. Thetransmission of lower policy rates to thecredit market has materialised with a lag.With most commercial banks reducing theirdeposit rates, the cost of funds has declinedenabling banks to reduce their BPLRs. Theeffective lending rates have also comedown as nearly three-fourths of banklending takes place at rates below theirBPLRs as alluded to before.

Growth Projection

60. During the first quarter of 2009-10,real GDP recorded a growth of 6.1 per cent,lower than the growth of 7.8 per cent in thecorresponding quarter of 2008-09, butmarginally higher than the 5.8 per centgrowth in the second half of 2008-09. Thesouth-west monsoon rainfall this year hasbeen the weakest since 1972 affecting bothyield and acreage of agricultural crops. Thiswill impact Kharif production and theperformance of agricultural productionduring the Rabi season will be critical forsupply management. On the whole,agricultural production in 2009-10 isexpected to be lower than in last year.

61. While external demand hascontinued to contract, large fiscal andmonetary stimulus measures havebolstered domestic consumption andhelped the recovery in the industrial sector.

II. Stance of Monetary Policy

23

The prospects of the industrial sector havebecome more promising than they were atthe time of the First Quarter Review. Withthe recovery in the stock market, theprimary segment of the capital market hasalso witnessed increased activity in therecent period. This, combined with theeasing of international financingconditions, augurs well for a pick-up ininvestment activity. The businessconfidence surveys also point to furtherimprovement in outlook despite weakperception of export demand.

62. Various services sector activities,which have slowed down significantly inthe recent period, should also catch up,albeit with a lag, in tandem withimproved industrial growth. Assuming amodest decline in agricultural productionand a faster recovery in industr ialproduction, the baseline projection forGDP growth for 2009-10 is placed at 6.0per cent with an upside bias (Chart 7).Thus, the GDP projection for 2009-10 forpolicy purposes remains unaltered fromthat made in the First Quarter Review ofJuly 2009.

Inflation Projection

63. Headline WPI inflation turnednegative during June-August 2009 due tothe large statistical base effect. Asanticipated in the First Quarter Review,WPI inflation has returned to positiveterritory, albeit a few weeks sooner thanexpected, in the wake of large increase inprices of food items and increase in globalcrude oil prices.

64. The upside risks on account ofdeficiency in monsoon rainfall indicated inFirst Quarter Review of July 2009 have nowmaterialised as prices of food items haverisen sharply. Going forward, Rabi cropprospects would be critical in shaping thepath of food inflation. The large stock offoodgrains with public agencies should helpmitigate any significant adverse impact dueto supply constraints. The improved termsof trade for agriculture in recent yearsshould provide an incentive to the sector.

65. Global commodity prices, whichhad bottomed out in early-2009, reboundedahead of global recovery. The global oilprices present a mixed picture. Crude oil

24

prices, which increased from their lowlevels of January-March 2009, haveremained range-bound since June 2009.Large global liquidity due to easy monetarypolicy followed by major central banks hasled to sizeable financialisation of thecommodities market, especially for thoseproducts that are prone to demand supplygaps. These developments may inducegreater volatility in commodity prices in thecoming years.

66. Inflation assessment has becomeincreasingly complex in recent times withthe WPI inflation rate remaining negativeor low and the various CPI inflationmeasures remaining close to or above thedouble digits for an extended period. CPIinflation has remained at an elevated levelsince March 2008 and did not decline asexpected in line with fall in WPI inflation.Indeed, it hardened due to sharp increasein essential commodity prices. The situationwas aggravated by the deficient monsoonrainfall and drought condition in severalparts of the country. The Reserve Bankmonitors an array of measures of inflation,both overall and disaggregatedcomponents, in conjunction with othereconomic and financial indicators, to assessthe underlying inflationary pressures andarticulates its policy stance in terms of WPI.The Government took a decision onOctober 19, 2009 to reduce the frequencyof the current series of Wholesale PriceIndex (base:1993-94) from weekly tomonthly. The available indices, WPI andthe four measures of CPI, fail to adequatelycapture the underlying inflationaryconditions because of inadequate coverageand also because the respective base yearsdo not capture the changed production and

consumption patterns. This underscoresthe need to expedite the revision ofcoverage and updating of the base year forthe WPI series as also the proposed twoconsumer price indices, i.e., CPI-Urbanand CPI-Rural.

67. The First Quarter Review of July2009 projected WPI inflation for end-March2010 at around 5.0 per cent. The JulyReview indicated that the risk to thisprojection was on the upside. Though theyear-on-year WPI inflation was 1.21per cent as on October 10, 2009, it hasalready increased by 5.95 per cent on afinancial year basis though some of theincrease is seasonal and is likely to soften.However, the base effect, which resultedin negative WPI inflation during June-August 2009, is now expected to work inthe reverse direction accentuated by highfood prices. The Reserve Bank’s quarterlyinflation expectations survey forhouseholds indicates that while inflationaryexpectations remain contained, a majorityof the respondents expect inflation rate toincrease over the next three months as alsoover the next year.

68. Keeping in view the global trendin commodity prices and the domesticdemand-supply balance, the baselineprojection for WPI inflation at end-March2010 is placed at 6.5 per cent with an upsidebias (Chart 8). This is higher than the 5.0per cent WPI inflation projected in the FirstQuarter Review of July 2009 as the upsiderisks have materialised.

69. As always, the Reserve Bank willendeavour to ensure price stability andanchor inflation expectations. The conductof monetary policy will continue to

25

condition and contain perception ofinflation in the range of 4.0-4.5 per cent.This will be in line with the medium-termobjective of 3.0 per cent inflation consistentwith India’s broader integration with theglobal economy.

Monetary Projection

70. The year-on-year growth in moneysupply (M

3) increased from 18.6 per cent

in end-March 2009 to 18.9 per cent byOctober 9, 2009. A major source of M

3

expansion this year has been the bankingsystem’s financing of the large marketborrowing of the Government, includingOMO purchases by the Reserve Bank. Thegrowth in bank credit to the commercialsector has moderated significantly to 10.7per cent from the high level of 27.4 per centa year ago.

71. The First Quarter Review of July2009 raised the indicative trajectory of M

3

growth to 18.0 per cent from 17.0 per centenvisaged in the Annual Policy Statementof April 2009 to ensure that the increasedgovernment market borrowing programmedid not crowd out the credit flow to theprivate sector. Over 80 per cent of the

market borrowing programme for 2009-10is now completed. In 2009-10 (up toOctober 9, 2009), credit has expanded byRs.1,14,800 crore. Thus, to attain theprojected growth of 20 per cent, banks willneed to expand credit by Rs.4,40,000 crorein the remaining part of the year, which willbe difficult unless demand for retail creditaccelerates. Also, access of corporates tonon-bank sources of financing, bothdomestic and international, has eased,which could lead to substitution of bankcredit. While credit demand is expected topick up during the second-half of 2009-10,attaining the projected growth of 20 per centis unlikely.

72. Keeping in view the borrowingrequirement of the government and of thecommercial sector in the remaining periodof 2009-10, the indicative projection ofmoney supply growth of 18.0 per cent setout in July 2009 is revised downwards to17.0 per cent. Consistent with this,aggregate deposits of scheduledcommercial banks are projected to grow by18.0 per cent. The growth in adjustednon-food credit, including investment inbonds/debentures/shares of public sector

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undertakings and private corporate sectorand CPs, is also revised downwards to 18.0per cent from 20.0 per cent set out in theAnnual Policy Statement and the FirstQuarter Review. Banks are urged onceagain to step up their efforts towards creditexpansion while preserving credit qualitywhich is critical for revival of growth.

Overall Assessment

73. There has been a discernibleimprovement in the global economicoutlook since the First Quarter Review inJuly 2009. In India too, there are definitiveindications of the economy reverting to thegrowth track. Accordingly, attention aroundthe world, as also in India, has shifted frommanaging the crisis to managing therecovery.

74. The policy dilemma for India isdifferent in some important respects fromthat of advanced economies as also otheremerging market economies. First, most ofthese countries do not face an immediaterisk of inflation. Indeed, in severaladvanced economies, the concerns wereabout a possible deflation, which are justabout waning. On the other hand, India isactively confronted with an upturn ininflation – a rising WPI inflation andstubbornly elevated CPI inflation.

75. Second, advanced economies arefaced with households, firms and financialinstitutions still struggling with theirimpaired balance sheets. Fortunately, wedo not have this problem in India, but westill have the challenge of revivingdomestic consumption and investmentdemand, the traditional, dominant driversof our growth.

76. Third, somewhat related to thepoint above, India has traditionally been asupply constrained economy in contrast toadvanced economies which are demandstarved. We need, in particular, to expandthe supply of infrastructure – power, roads,urban infrastructure and socialinfrastructure. The supply constraints whichremained subdued during the crisis periodowing to weak demand, will re-emerge andmay indeed become binding.

77. Fourth and importantly, India is oneof the few large emerging economies withtwin deficits – fiscal and current accountdeficits. While our current account deficitis modest, and may even be benign giventhe investment requirements of theeconomy, there can be no two views aboutthe need to make a responsible, credible andtime-bound fiscal adjustment. Thearguments for fiscal consolidation andrectitude are compelling and widely known,and need not be repeated here. But an issueof some immediate relevance is the criticalneed to downsize the government borrowingprogramme so as to help sustain a moderateinterest rate regime. This is crucial forinvestment demand to pick up on whichhinge our long-term economic prospects.

78. Around the world, there is anactive, and at times animated debate onthe timing and sequencing of exit from theexpansionary monetary stance. ‘Exit’ is acentral issue in our policy matrix too. Asthe Reserve Bank has indicated in severalpublic statements, our current monetarystance is not the steady state and we needto reverse the expansionary stance. It isimportant to recognise though that theexit debate in India is qualitatively

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different from that in other advanced andemerging economies because of the uniquefeatures of our macroeconomic contextindicated above.

79. The precise challenge for theReserve Bank is to support the recoveryprocess without compromising on pricestability. This calls for a careful managementof trade-offs. Growth drivers warrant adelayed exit, while inflation concerns callfor an early exit. Premature exit will derailthe fragile growth, but a delayed exit canpotentially engender inflation expectations.

80. The Reserve Bank has consulted awide array of stakeholders in the run up tothis policy review. Based on theseconsultations, the arguments for and againstreversal of the expansionary monetarypolicy stance can be summarised as follows.

Arguments for Beginning Reversal ofMonetary Easing

81. The most dominant argument forreversing monetary policy easing stemsfrom the concern about inflation. WPIinflation has turned positive, the base effectwhich has kept WPI low so far is now goneand CPI inflation has remained stubbornlyelevated. On a financial year basis, WPIhas already increased by 5.95 per cent.Inasmuch as monetary policy acts with alag, there is need to act now.

82. It is further argued that even thoughthe current inflationary pressures are drivenby food prices, they can strengthenexpectations of higher inflation and lead togeneralised inflation. The Reserve Bank’sinflation expectations survey shows thathouseholds expect inflation to increase over

the next three months as also one year. Thelag with which monetary policy operatessuggests that there is a case for tighteningsooner rather than later.

83. Forceful arguments for earlyreversal of monetary policy also arise fromliquidity concerns. The LAF window hasbeen absorbing over Rs.100,000 crore on adaily basis since May 2009, save for a fewdays on account of temporary increases ingovernment balances. This evidences thelarge amount of liquidity in the systemwhich could potentially result in anunsustainable asset price build-up. There isalready some evidence of excess liquidityfeeding through asset prices with potentialfinancial stability concerns. Further, capitalflows have resumed. Given the limitationsof the economy’s current absorptivecapacity, these flows will add to the overalldomestic liquidity, further fuelling the assetprice build-up. Large capital inflows andasset price inflation have the potential tofeed on each other. From the liquiditydimension, it is further argued that thecurrent large overhang of liquidity couldengender inflation expectation even if creditdemand remains subdued.

Arguments for Deferring Reversal ofMonetary Easing

84. The dominant argument forcontinuing with the current monetary stanceis that the recovery is as yet fragile. Exportsare still on the decline and the recentimprovement in industrial productionoverstates the recovery as part of it is dueto the base effect and the one time impactof restocking inventory. Prematuretightening will hurt the growth impulses.

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On the other hand, it is imperative tocontinue with the accommodative stance tocompensate for the decline in agriculturaloutput and till there is firm evidence ofsustained global recovery.

85. The second argument against animmediate reversal of monetary easing isthat the current inflationary pressures aredriven by supply side constraints,particularly food prices. Monetary policyis typically not an efficient instrument forreining in food price inflation. There could,of course, be concerns that rising food pricescould spark inflationary expectations. Butthe probability of that is low as food pricesare likely to ease in the coming monthsfollowing the seasonal trend. The promisingRabi crop prospects also will reduce foodprice pressures. Under these circumstances,the downside risks to any tightening noware high with virtually no upside.

86. The third argument for maintainingthe accommodative monetary stance fornow is that any reversal at this stage willharden yields on government bonds puttingupward pressure on interest rates anddampening both consumption andinvestment demand. This could seriouslyunravel the incipient recovery.

87. Finally, capital flows have resumedon the promise of India’s growth prospects.It is argued that if we tighten ahead of othereconomies, the wider interest rate differentialwill become a perverse incentive for evenlarger capital flows. In managing capitalflows in excess of the current account deficit,the economy will have to pay a cost whichwill be a combination of exchange rateappreciation, larger systemic liquidity andfiscal costs of sterilisation.

88. The Reserve Bank has studiedthese arguments. Some of the arguments arepersuasive and some less so. The balanceof judgment at the current juncture is thatit may be appropriate to sequence the ‘exit’in a calibrated way so that while therecovery process is not hampered, inflationexpectations remain anchored. The ‘exit’process can begin with the closure of somespecial liquidity support measures.

89. It will be recalled that in responseto the crisis, like most other central banks,the Reserve Bank too instituted bothconventional measures and unconventionalmeasures. While reversing of conventionalmeasures is not considered appropriate fornow, many of the unconventional measurescan be reversed immediately. The followingmeasures constitute the first phase of ‘exit’.

90. The statutory liquidity ratio (SLR),which was reduced from 25 per cent ofdemand and time liabilities to 24 per cent,is being restored to 25 per cent. The limitfor export credit refinance facility [(undersection 17(3A) of the RBI Act], which wasraised to 50 per cent of eligible outstandingexport credit, is being returned to thepre-crisis level of 15 per cent. The twonon-standard refinance facilities: (i) specialrefinance facility for scheduled commercialbanks under section 17(3B) of the RBI Act(available up to March 31, 2010), and(ii) special term repo facility for scheduledcommercial banks (for funding to MFs,NBFCs, and HFCs) (available up to March31, 2010) are being discontinued withimmediate effect. Details in this regard areindicated in the subsequent sections of thisStatement.

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Policy Stance

91. On the basis of the above overallassessment, the stance of monetary policyfor the remaining period of 2009-10 willbe as follows:

• Keep a vigil on the trends in inflationand be prepared to respond swiftly andeffectively through policy adjustmentsto stabilise inflation expectations.

• Monitor the liquidity situation closelyand manage it actively to ensure thatcredit demands of productive sectors are

adequately met while also securing pricestability and financial stability.

• Maintain a monetary and interest rateregime consistent with price stabilityand financial stability, and supportive ofthe growth process.

92. In conclusion, it bears emphasis thatthe Reserve Bank is mindful of itsfundamental commitment to price stability.It will continue to monitor the price situationin its entirety and will take measures aswarranted by the evolving macroeconomicconditions swiftly and effectively.

Bank Rate

93. The Bank Rate has been retainedunchanged at 6.0 per cent.

Repo Rate

94. The repo rate under the LiquidityAdjustment Facility (LAF) has beenretained unchanged at 4.75 per cent.

Reverse Repo Rate

95. The reverse repo rate under theLAF has been retained unchanged at 3.25per cent.

96. The Reserve Bank has theflexibility to conduct repo/reverse repoauctions at a fixed rate or at variable ratesas circumstances warrant.

97. The Reserve Bank retains the optionto conduct overnight or longer term repo/reverse repo under the LAF depending onmarket conditions and other relevant factors.The Reserve Bank will continue to use this

flexibly including the right to accept or rejecttender(s) under the LAF, wholly or partially,so as to make efficient use of the LAF indaily liquidity management.

Cash Reserve Ratio

98. The cash reserve ratio (CRR) ofscheduled banks has been retainedunchanged at 5.0 per cent of their net demandand time liabilities (NDTL).

99. The collateralised borrowing andlending obligation (CBLO) liabilities ofscheduled banks were exempted fromCRR prescription in order to developCBLO as a money market instrument.Volumes in the CBLO segment haveincreased over the years, especially afterthe phasing out of the non-banks from theinter-bank market. The daily averagevolume in the CBLO segment, which wasonly Rs.6 crore in January 2003, is nowover Rs.60,000 crore. Since the objectiveof developing CBLO as a money market

III. Monetary Measures

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instrument has been broadly achieved, itis proposed that:

• liabilities of scheduled banks arisingfrom transactions in CBLO withClearing Corporation of India Ltd.(CCIL) will be subject to maintenanceof CRR with effect from the fortnightbeginning November 21, 2009.

Statutory Liquidity Ratio

100. In view of difficult macroeconomicsituation and liquidity conditions in theglobal and domestic financial markets afterthe collapse of Lehman Brothers, thestatutory liquidity ratio (SLR) of scheduledcommercial banks (SCBs) was reduced from25 per cent to 24 per cent of their NDTLwith effect from November 8, 2008. Theliquidity situation has remained comfortablesince mid-November 2008 as reflected in the

surplus funds being placed by banks dailyin the LAF window of the Reserve Bank.Accordingly, it has been decided to:

• restore the SLR for scheduledcommercial banks to 25 per cent oftheir NDTL with effect from thefortnight beginning November 7, 2009.

101. SCBs are currently maintainingSLR investments at 27.6 per cent of theirNDTL, net of LAF collateral securities, and30.4 per cent of NDTL, inclusive of LAFcollateral securities. As such, the increasein the SLR will not impact the liquidityposition of the banking system and creditto the private sector.

Third Quarter Review

102. The Third Quarter Review ofMonetary Policy for 2009-10 will beundertaken on January 29, 2010.

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103. The global financial crisis raisedissues that we thought were settled andreopened questions that we thought hadbeen answered. It also pointed to theegregious policies and practices in financialsector regulation and supervision.Reflecting the lessons of the crisis, there isnow active debate and discussion at theglobal level on reforming the regulatorystructures and supervisory processes. Thisis expected to be a continuous process withreform packages being agreed upon andfinalised in a modular fashion on a regularbasis over the next couple of years.

104. India has been less affected by thecrisis than most other countries because ofour relatively cautious policies, prudentregulation and effective supervision.Nonetheless, there are lessons from thecrisis for India too, which include:(i) further strengthening regulation at thesystemic and institutional levels; (ii) makingour supervision more effective and valueadding; and (iii) improving our skills in riskmanagement. India has been an active

participant at the global discussions. Thetask for us will be to reflect our point ofview in the global debate and adapt theglobal policies and guidelines to the Indiansituation on a dynamic basis. A task thatthe Reserve Bank has all along beenperforming but is now explicitly defined ismonitoring and ensuring financial stability.Furthermore, we need to actively pursue thechallenge of financial inclusion.

105. Reform is a continuous process.Over the last several years, the Reserve Bankhas endeavoured to make reforms aconsultative and participative endeavour. Itis now standard practice for the ReserveBank to consult stakeholders before policyreviews, seek comments from experts, placedraft policy proposals on its website forfeedback and to disseminate policies widely.We will continue to improve these practices.

106. A synopsis of the action taken andstatus of past policy announcementstogether with a listing of fresh policies isset out below.

Part B. Developmental and Regulatory Policies

I. Financial Stability

107. At the recently held G-20 Summitduring September 24-25, 2009 inPittsburgh, it was decided, among others,to make sure that the global regulatorysystem for banks and other financialfirms reins in the excesses that led to thecrisis and as such committed to: (i) raisecapital standards; (ii) implement stronginternational compensation standardsaimed at ending practices that led to

excessive risk-taking; (iii) improve theover-the-counter (OTC) derivativesmarket; (iv) create more powerful tools tohold large global firms to account for therisks they take; and (v) ensure that standardsfor large global financial firms arecommensurate with the cost of theirfailure. It was also agreed to reform theglobal architecture to meet the needs ofthe 21st century.

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108. Keeping in view both internationaland domestic initiatives in the financialsector, the Annual Policy Statement ofApril 2009 indicated setting up of aFinancial Stability Unit (FSU) in theReserve Bank. Accordingly, the FSU wasconstituted in July 2009 drawing uponinter-disciplinary expertise from theregulatory, supervisory, statistics, economicsand financial markets departments of theReserve Bank. The FSU will: (i) conductmacro-prudential surveillance of thefinancial system on an ongoing basis;

(ii) prepare financial stability reports;(iii) develop database of key variableswhich could impact financial stabilityand a time series of a core set of financialindicators; (iv) conduct systemic stresstests to assess resilience; and (v) developmodels for assessing financial stability.The FSU also provides the secretariat tothe Reserve Bank’s representative in theFinancial Stability Board (FSB). TheFSU is expected to bring out the firstFinancial Stabili ty Report by end-December 2009.

II. Interest Rate Policy

BPLR System: Review

109. The Annual Policy Statement ofApril 2009 proposed constituting a WorkingGroup to review the present benchmarkprime lending rate (BPLR) system andsuggest changes to make credit pricingmore transparent. Accordingly, a WorkingGroup (Chairman: Shri Deepak Mohanty)

was constituted in June 2009 and the Groupsubmitted its Report on October 20, 2009.The Report of the Working Group was alsoplaced on the Reserve Bank’s website on thesame day for comments and suggestions.The Reserve Bank will consider therecommendations after taking into accountthe feedback received on the Report.

III. Financial Markets

Financial Market Products

Interest Rate Futures

110. The Annual Policy Statement ofApril 2009 had indicated launching ofexchange traded interest rate futures (IRFs)contracts on the 10-year notional couponbearing Government of India bond.Accordingly, in consultation with theSecurities and Exchange Board of India(SEBI), IRFs were introduced and thedirections covering the framework fortrading of IRFs on recognised exchanges

were placed on the Reserve Bank’s websitein August 2009. The National StockExchange (NSE) commenced trading inIRFs on August 31, 2009.

Introduction of Repo in Corporate Bonds

111. The Reserve Bank had placed onits website, on September 17, 2009, thedraft guidelines on repo in corporate bondsfor comments/feedback. The draftguidelines were also deliberated by theTechnical Advisory Committee (TAC) on

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Money, Foreign Exchange and GovernmentSecurities Markets at its meeting held onSeptember 23, 2009. With DvP-I (trade-by-trade) based clearing and settlement systemfor OTC trades in corporate bonds beingoperationalised by the clearing houses ofthe exchanges, repo in corporate bonds cannow be introduced. Accordingly:

• final guidelines on repo in corporatebonds will be issued by end-November2009.

Regulation of Non-ConvertibleDebentures (NCDs) of Maturity ofLess than One Year

112. At present, issuance of non-convertible debentures (NCDs) withmaturity of less than one year is not subjectedto regulation by the SEBI or the Governmentof India. It was decided in the High LevelCoordination Committee on FinancialMarkets (HLCCFM) that such instrumentsbeing ‘money market instruments’ neededto be brought under the regulation of theReserve Bank. A Working Group withrepresentation from the Reserve Bank andthe SEBI was, therefore, set up to examinethe issue. The Working Group, which hassince submitted its Report, hasrecommended that the Reserve Bank mayframe regulations on issuance of NCDs withmaturity of less than one year, asthey fall under the definition of ‘moneymarket instruments’ of Chapter IIID ofthe Reserve Bank of India (Amendment) Act,2006. The recommendations of the WorkingGroup were discussed in the meeting of theTAC on Money, Foreign Exchange andGovernment Securities Markets onSeptember 23, 2009 and it was agreed thatthe Reserve Bank may frame regulations on

the lines of the guidelines for issuance ofcommercial paper (CP). Accordingly:

• draft guidelines are being formulatedwhich will be placed on the ReserveBank’s website by end-November 2009for comments/suggestions.

Introduction of Credit DefaultSwaps (CDS)

113. In 2007, the Reserve Bank hadissued draft guidelines for introduction ofcredit default swaps (CDS) in India.However, the issuance of final guidelineswas kept in abeyance keeping in view therole of credit derivatives in the recentfinancial crisis. It was consideredappropriate to proceed with cautionreflecting the lessons from the financialcrisis in this regard. In order to align withthe international work already conducted/underway in the area of credit derivatives,and keeping in view the specifics of theIndian markets, it is proposed:

• to in t roduce pla in vani l la OTCsingle-name CDS for corporate bondsfor resident entities subject toappropriate safeguards. To begin with,all CDS trades will be required to bereported to a centralised trade reportingplatform and in due course they will bebrought on a central clearing platform.

114. The Reserve Bank is setting up aninternal Group to finalise the operationalframework in consultation with marketparticipants.

Separate Trading for RegisteredInterest and Principal of Securities(STRIPS)

115. As indicated in the Annual PolicyStatement of April 2009, the draft

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guidelines on stripping/reconstitution ofgovernment securities were placed on theReserve Bank’s website on May 1, 2009inviting comments/suggestions frommarket participants by May 29, 2009. Basedon the feedback/suggestions received fromthe market participants, the guidelines havebeen finalised. Banks will be permitted tostrip/reconstitute eligible securities held intheir held to maturity (HTM)/available forsale (AFS)/held for trade (HFT) portfolios.Accordingly:

• STRIPS will be launched, as scheduled,during the current financial year.

Floating Rate Bonds (FRBs)

116. As announced in the Annual PolicyStatement of April 2009, the issuancestructure of floating rate bonds (FRBs) hasbeen revised, addressing issues relating toproduct design. The FRBs will henceforthbe issued by way of ‘price-based’ auctionas against the earlier ‘spread-based’ auction.The revised issuance structure of FRBshas been built into the negotiated dealingsystem (NDS) auction platform, whichwas operationalised on May 11, 2009.Accordingly:

• floating rate bonds will be issued duringthe current financial year dependingupon the market conditions and marketappetite.

Expansion of Currency Pairs ofCurrency Futures Contracts

117. Currently, persons resident in Indiaare permitted to trade in US dollar-Indianrupee (INR) currency futures contracts inthree recognised stock exchanges. The

combined average daily turnover of thecontracts in all the three exchangesincreased from US$ 1.1 billion in March2009 to US$ 2.5 billion in September 2009.Market participants have been representingthat trading of currency future contracts inother major currency pairs may also bepermitted to facilitate direct hedging of theirrisk in such currencies. Accordingly, it isproposed:

• to permit the recognised stock exchangesto offer currency futures contracts incurrency pairs of Euro-INR, JapaneseYen-INR and Pound Sterling-INR, inaddition to US dollar-rupee contractswhich are already permitted.

118. Necessary amendments toCurrency Futures (Reserve Bank)Directions, 2008 are being made separately.

Guidelines on Forex, Commodityand Freight Derivatives

119. In light of the developments in thedomestic and international financialmarkets and based on the feedback receivedfrom banks, market participants, industryassociations and others , the existingguidelines on foreign exchange andcommodity and freight derivatives overseashave been reviewed by an internal Group.The draft proposals were discussed in themeeting of the TAC on Money, ForeignExchange and Government SecuritiesMarkets. Accordingly:

• the draft guidelines are being placedon the Reserve Bank’s website byend-November 2009 for widerdissemination and comments/views.

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Financial Market Infrastructure

Revision of Repo Accounting

120. The Annual Policy Statement ofApril 2009 had indicated issuance ofrevised guidelines on repo accountingtaking into account comments on the draftguidelines earlier placed on the ReserveBank’s website for implementation fromApril 1, 2010. Accordingly:

• the final guidelines are underconsideration and will be issued byend-November 2009.

Clearing and Settlement of OTC Tradesin Corporate Bonds: Status

121. As announced in the Annual PolicyStatement of April 2009, the clearinghouses of the exchanges, viz., NationalSecurities Clearing Corporation Limited(NSCCL) and Indian Clearing CorporationLimited (ICCL) have been permitted tomaintain transitory pooling accounts withthe Reserve Bank for facilitating settlementof OTC transactions in corporate bonds inthe real time gross settlement (RTGS)system on a DvP-I basis (i.e., on a trade-by-trade basis). The Reserve Bank andSEBI have issued necessary instructionsrequiring specified regulated entities toclear and settle all OTC trades in corporatebonds through the NSCCL or ICCL witheffect from December 1, 2009.

Money Market

Refinance/Special Liquidity Facilities

122. As indicated in the Annual PolicyStatement of April 2009, the followingliquidity facilities provided by the ReserveBank to banks and financial institutions are

available up to March 31, 2010: (i) the exportcredit refinance (ECR) facility (limit up to50 per cent of eligible outstanding rupeeexport credit) under Section 17(3A) of theReserve Bank of India Act (RBI); (ii) thespecial refinance facility for scheduledcommercial banks [limit up to one per centof net demand and time liabilities (NDTL)as on October 24, 2008] under Section17(3B) of the RBI Act; (iii) special term repofacility to scheduled commercial banks forfunding to mutual funds (MFs), non-bankingfinancial companies (NBFCs) and housingfinance companies (HFCs) [limit is in termsof relaxation in the statutory liquidityratio (SLR) up to 1.5 per cent of NDTL];(iv) refinance facility to Small IndustriesDevelopment Bank of India (SIDBI),National Housing Bank (NHB) andExport- Import Bank of India (EXIM Bank)[under Section 17(4H), Section 17(4DD) andSection 17(4J), respectively, of the RBI Act];and (v) the forex swap facility to banks fortenor up to three months.

123. A review of these facilities,indicated that the utilisation of these facilitieshas been low. Keeping this in view andtaking into account the current liquidityconditions in the markets, it is proposed totake the following actions with immediateeffect:

• to reduce the limit of export creditrefinance facility from 50 per cent to15 per cent of eligible outstanding rupeeexport credit extended under Section17(3A) of the RBI Act;

• to discontinue the special refinancefacility for scheduled commercial banksinstituted under Section 17(3B) of theRBI Act;

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• to discontinue the special term repofacility for scheduled commercial banksfor funding to mutual funds, non-bankingfinancial companies and housing financecompanies; and

• to discontinue the forex swap facility ofbanks.

124. The refinance facility to SIDBI,NHB and EXIM Bank [under Section17(4H), Section 17(4DD) and Section17(4J), respectively, of the RBI Act]will continue to be in operation till thepre-announced date of March 31, 2010.However, these three financial institutions(FIs) will have to ensure that alloutstandings are repaid by the close ofbusiness on March 31, 2010.

Government Securities Market

Auction Process of Government ofIndia Securities: Status

125. As indicated in the Annual PolicyStatement of April 2009, the specificnotification for auction for sale ofgovernment securities along with thescheme for non-competitive bidding facilityhas been amended by the Government ofIndia in consultation with the ReserveBank. Accordingly, the remainingrecommendations of the internal WorkingGroup (Chairman: H.R. Khan) pertaining tothe Reserve Bank such as: (i) withdrawalof the facility of bidding in physical form

and submission of competitive bids onlythrough the NDS; and (ii) submission of asingle consolidated bid on behalf of all itsconstituents by the bank/primary dealer(PD) in respect of non-competitive bids,have been implemented with effect fromMay 22, 2009. The implementation of therecommendations of the Working Grouphas improved the efficiency of the auctionprocess by reducing the time taken forannouncement of the auction results,thereby enhancing the time available fortrading in the auctioned securities.

Non-Competitive Bidding in the Auctionof State Development Loans (SDLs):Status

126. In order to widen the investor baseand enhance the liquidity for StateDevelopment Loans (SDLs), a scheme fornon-competitive bidding in the auction ofSDLs was notified by all State Governmentson July 20, 2007. In pursuance of theannouncement made in the Annual PolicyStatement of April 2009, the scheme fornon-competitive bidding in SDLs has beenoperationalised with effect from August 25,2009. Under the scheme, up to 10 per centof the notified amount of SDLs will beallotted to eligible individuals and institutions,subject to a maximum of one per cent of thenotified amount for single bid per stock. Aninvestor can submit only a single bid in anauction of SDL through a bank or PD.

IV. Credit Delivery Mechanism and Other Banking Services

Credit Flow to the MSE Sector

127. As indicated in the Annual PolicyStatement of April 2009, the guidelines basedon the Working Group on Rehabilitation of

Sick SMEs (Chairman: Dr. K.C. Chakrabarty)

were issued to scheduled commercial banks

in May 2009. In pursuance of the guidelines,

banks were advised to review/put in place

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policies for the micro and small enterprises(MSEs), duly approved by their respectiveBoards with regard to: (i) loan policygoverning extension of credit facilities;(ii) restructuring/rehabilitation policy forrevival of potentially viable sick units/enterprises; and (iii) non-discretionary one-time settlement scheme for recovery of non-performing loans. Other recommendationspertaining to the Government of India/StateGovernments/State Level Bankers’Committee (SLBC) convener banks wereforwarded to them for necessary action. Theregional offices of the Reserve Bank wereadvised to monitor the actions initiated bythe State Governments/SLBC convenerbanks and discuss the progress in this regardin the SLBC meetings.

128. The Annual Policy Statement ofApril 2009 also proposed that the StandingAdvisory Committee on MSEs wouldreview the credit guarantee scheme.Accordingly, a Working Group (Chairman:Shri V. K. Sharma) was constituted toreview the credit guarantee scheme of theCredit Guarantee Fund Trust for Micro andSmall Enterprises (CGFTMSE) and alsoexamine the feasibility of a ‘whole turnoverguarantee’ for the MSE portfolio. TheWorking Group is expected to submit itsreport by end-December 2009.

Agricultural Debt Waiver and DebtRelief Scheme, 2008: Status

129. A scheme of agricultural debtwaiver and debt relief for farmers with thetotal value of overdue loans being waivedestimated at Rs.50,000 crore and a one-timesettlement (OTS) relief on the overdueloans estimated at Rs.10,000 crore was

announced in the Union Budget 2008-09.Out of this, Rs.28,000 crore was passed onto the National Bank for Agriculture andRural Development (NABARD) forreimbursing the claims of regional ruralbanks (RRBs) and co-operatives and theremaining amount was earmarked forreimbursing the claims of scheduledcommercial banks (SCBs), local areabanks (LABs) and urban co-operativebanks (UCBs). Till date, SCBs and UCBshave been reimbursed to the extent of64.7 per cent of their ‘debt waiver’ claims.

Rural Co-operative Banks

Licensing of Co-operatives: Status

130. The Committee on Financial SectorAssessment (Chairman: Dr. Rakesh Mohanand Co-Chairman: Shri Ashok Chawla) hadrecommended that rural co-operative bankswhich fail to obtain a license by 2012should not be allowed to continue tooperate. Accordingly, it was proposed, inthe Annual Policy Statement of April 2009,to work out a roadmap for achieving thisobjective in a non-disruptive manner. Thecriteria for licensing of these banks havebeen drafted in consultation with theNABARD and action with regard toissuance of licenses has been initiated. Atpresent, 17 out of 31 state co-operativebanks, and 296 out of 371 central co-operativebanks are unlicensed.

Revival of Rural Co-operative CreditStructure: Status

131. Based on the recommendationso f t h e Ta s k F o r c e o n R e v i v a l o fRural Co-operative Credit Institutions

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(Chairman: Prof. A. Vaidyanathan) and inconsultation with the State Governments,the Government of India had approved apackage for revival of the short-term ruralco-operative credit structure. So far, asenvisaged under the package, 25 Stateshave entered into Memorandum ofUnderstanding (MoU) with theGovernment of India and the NABARD.Twelve States have made amendments totheir respective Co-operative Societies Acts.As on July 31, 2009, an aggregate amountof Rs.6,639 crore has been released by theNABARD as Government of India’s shareunder the package to primary agriculturalcredit societies (PACS) in 10 States. TheNational Implementing and MonitoringCommittee (NIMC) set up by theGovernment of India is monitoring theimplementation of the revival package.

132. Furthermore, a study of the long-termco-operative credit structure was entrustedby the Government of India to the sameTask Force. The Task Force submitted itsreport in August 2006. It was announced inthe Union Budget 2008-09 that theGovernment of India and the StateGovernments have reached an agreementon the content of the package for the revivalof the long-term co-operative creditstructure. The cost of the package has beenestimated at Rs.3,074 crore, of which theCentral Government’s share will beRs.2,642 crore. The Government ofIndia has constituted a Task Force(Chairman: Shri G. C. Chaturvedi) inSeptember 2009 with representatives fromthe Reserve Bank and the NABARD to lookinto the various aspects of the long-termco-operative credit structure with regard to

viability, relevance of a separate packageand strategy for implementation.

Regional Rural Banks

Capital to Risk-weighted Assets Ratio(CRAR) for RRBs: Status

133. On the basis of the recommendationsof the Committee on Financial SectorAssessment (Chairman: Dr. Rakesh Mohanand Co-Chairman: Shri Ashok Chawla), theAnnual Policy Statement of April 2009proposed to introduce CRAR for RRBs in aphased manner, taking into account the statusof recapitalisation and amalgamation. TheGovernment of India has constituted aCommittee (Chairman: Dr. K.C. Chakrabarty)with representatives from the Government,sponsor banks, RRBs and the NABARD toexamine the financials of the RRBs andsuggest a roadmap to raise the CRAR ofRRBs to nine per cent by March 2012. TheCommittee is expected to submit its reportby end-January 2010.

Amalgamation of RRBs: Status

134. Of the total number of 196 RRBs,159 RRBs have been amalgamated into 46new RRBs (sponsored by 27 banks andlocated in 26 States including one UnionTerritory). Since then one new RRB hasalso been established in the Union Territoryof Puducherry. Accordingly, the totalnumber of RRBs now functioning is 84.

Recapitalisation of RRBs: Status

135 The Union Budget 2007-08announced that RRBs which have anegative net worth will be recapitalised in

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a phased manner. The process ofrecapitalisation has since been completedwith 27 RRBs having been fullyrecapitalised with an amount of Rs.1,796crore as on July 31, 2009.

Technology Upgradation of RRBs: Status

136. With a view to enabling RRBs toadopt information technology (IT)-basedsolutions for financial inclusion, it wasproposed in the Annual Policy Statementof April 2009 to work out, in consultationwith the NABARD, the manner of providingassistance to RRBs for adopting informationand communication technology (ICT)solutions for financial inclusion in districtsidentified as having high level of exclusionby the Committee on Financial Inclusion(Chairman: Dr. C. Rangarajan). To facilitateICT implementation, there is a need toimplement core banking solutions (CBS). Inthis context, the Report of the internalWorking Group (Chairman: Shri G.Srinivasan) constituted by the ReserveBank to prepare a roadmap for migrationto CBS by RRBs was forwarded to allsponsor banks in October 2008 with anadvice to implement the recommendationsin respect of RRBs sponsored by them. Theissue of sharing the funding cost of CBSproject among the owners of RRBs, viz.,the Government of India, the StateGovernments and sponsor banks, is underexamination by the NABARD.

Urban Co-operative Banks

Review of Regulatory and SupervisoryFramework for UCBs: Status

137. The Annual Policy Statement ofApril 2009 proposed a review of the

existing instructions on internal control,risk management system, asset-liabilitymanagement (ALM) and disclosure normsas appropriate to UCBs as also to applycapital charge for market risk in respect oflarge-sized and systemically importantUCBs. The review is underway.

Information Technology Support toUCBs: Status

138. Based on the recommendations ofthe Working Group (Chairman: Shri R.Gandhi), which looked into ways ofsupporting IT initiatives of the UCBs, atentative action plan has been worked out.Taking into account a large number of smalland unit UCBs and the lack of uniformityin the level of computerisation, the actionplan envisages the minimum level of ITinfrastructure to include computerisedmanagement information system (MIS)reporting and automated regulatoryreporting (ARR). After a series ofdiscussions with service providers, it hasbeen decided to adopt the applicationservice provider (ASP) model for providingIT support to UCBs. The modalities arebeing worked out in consultation with theInstitute for Development and Research inBanking Technology (IDRBT).

Creation of Umbrella Organisation andRevival Fund for UCBs: Status

139. As indicated in the Annual PolicyStatement of April 2008, a Working Group(Chairman: Shri V. S. Das) was constitutedto suggest measures, including theappropriate regulatory and supervisoryframework, to facilitate emergence ofumbrella organisation(s) for the UCB sector

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in the respective States. The Group hassince submitted its Report.

DICGC-Supported Transfer of Assetsand Liabilities of UCBs to CommercialBanks in Legacy Cases

140. As a part of the measures tostrengthen the urban co-operative bankingsystem, a scheme of amalgamation of weakUCBs with strong UCBs, with support fromthe Deposit Insurance and Credit GuaranteeCorporation (DICGC), is considered by theReserve Bank in cases involving UCBshaving negative net worth as on March 31,

2007. However, in those cases, whereproposals for amalgamation within the UCBsector are not forthcoming, it is proposed:

• to provide DICGC support to the schemeinvolving transfer of assets and liabilities(including branches) of legacy cases ofurban co-operative banks to domesticscheduled commercial banks, provided thescheme ensures 100 per cent protectionto depositors and DICGC support isrestricted to the amount as provided underSection 16 (2) of the DICGC Act, 1961.

141. Detailed guidelines in this regardwill be issued separately.

V. Financial Inclusion

Business Correspondent (BC) Model

142. As proposed in the Annual PolicyStatement of April 2009, a Working Group(Chairman: Shri P. Vijaya Bhaskar) wasconstituted to examine the experiencegained to date with the businesscorrespondent (BC) model and to suggestmeasures to enlarge the category of personsthat can act as BCs, keeping in view theregulatory and supervisory framework andconsumer protection issues. The Group’sReport has been placed on the ReserveBank’s website. Based on the Group’srecommendations, it is proposed:

• to allow banks to appoint the followingentities as BCs in addition to thosepermitted already: (i) individualkirana/medical/fair price shop owners;(ii) individual public call office (PCO)operators; (iii) agents of small savingsschemes of Government of India/insurance companies; (iv) individuals

who own petrol pumps; (v) retiredteachers; and (vi) authorised functionariesof well-run self-help groups (SHGs)linked to banks; and

• to allow banks to collect reasonableservice charges from the customer in atransparent manner under their Board-approved policy for delivering theservices through BC. This should beclearly explained to the customer.

143. Based on the experience gained,the working of the scheme will be reviewedafter one year.

Pilot Project of SLBCs for 100 per centFinancial Inclusion

144. Of the total of 623 districts in thecountry, 431 districts have so far beenidentified for 100 per cent financialinclusion. Of these, 204 districts in 18States and six Union Territories havereported having achieved the target. All

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districts of Haryana, Himachal Pradesh,Karnataka, Kerala, Uttarakhand, Goa,Chandigarh, Puducherry, Daman & Diu,Dadra & Nagar Haveli and Lakshdweephave reported having achieved 100 per centfinancial inclusion. The Reserve Bank hadundertaken an evaluation study throughexternal agencies in 26 districts of eightStates claiming 100 per cent financialinclusion, to draw lessons for further action.The study reports had, inter alia, revealedthat although the SLBCs had declaredseveral districts as 100 per cent financiallyincluded, the actual financial inclusion wasshort of that. A large number of no-frillsaccounts are dormant, the number oftransactions is small and ICT-basedfinancial services are yet to reach manyvillages. The findings of the study werecommunicated to banks in January 2009with an advice to take appropriate action.

Special Task Force in North-EasternRegion

145. The Annual Policy Statement ofApril 2009 had indicated the formulationof a scheme of providing financial supportto banks by the Reserve Bank for settingup banking facilities at centres in theNorth-Eastern region which were found tobe commercially viable by banks, providedthe State Governments made availablenecessary premises and other infrastructuralsupport. As its contribution, the ReserveBank would bear one-time capital cost andrecurring expenses for a limited period offive years as per the lowest bid offered bya bank. The Government of Meghalaya hassince agreed to the proposal of providingpremises and security. Accordingly, eight

centres have been allotted to three publicsector banks. Action has also been initiatedin respect of other States in the region.

Quicker Adoption of Electronic BenefitTransfer (EBT) for GovernmentSchemes

146. To encourage banks to adopt ICTsolutions for enhancing their outreach, theReserve Bank formulated a scheme toquicken the pace of adoption of the smartcard-based electronic benefit transfer (EBT)mechanism by banks and rolled out the EBTsystem in the States that are ready to adoptthe scheme. As per the scheme, the ReserveBank would reimburse the banks a part ofthe cost of opening accounts with bio-metricaccess/smart cards at the rate of Rs.50 peraccount through which payment of socialsecurity benefits, National Rural EmploymentGuarantee Act (NREGA) payments andpayments under other Government benefitprogrammes would be routed to personsbelonging to below poverty line (BPL)families. The scheme is currently beingimplemented in Andhra Pradesh. So far,seven banks have been paid Rs.1.8 crore forsmart cards issued by banks in AndhraPradesh during July-December 2008. Theprocess is at different stages ofimplementation in other States such asKarnataka and Uttarakhand and the schemeof partial reimbursement by the ReserveBank has been extended by one year up toJune 30, 2010. Banks are advised to workin co-ordination with the respectivegovernment departments at the Central andState levels to ensure that all State benefitsare delivered to individuals only throughbank accounts within a specific timeframe.

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High Level Committee onLead Bank Scheme

147. The High Level Committee on LeadBank Scheme (Chairperson: Smt. Usha Thorat)submitted its draft report on May 21, 2009.The Report was placed on the ReserveBank’s website inviting comments frompublic and other stakeholders. Based on thefeedback received, the Committeesubmitted its final report to the ReserveBank on August 20, 2009 and the reportwas placed on the Reserve Bank’s websiteon August 24, 2009. While therecommendations of the Committee areunder consideration, it is proposed:

• to advise the lead banks to constitute aSub-Committee of the DistrictConsultative Committees (DCCs) todraw up a roadmap by March 2010 toprovide banking services through abanking outlet in every village having apopulation of over 2,000, by March2011. Such banking services may notnecessarily be extended through abrick and mortar branch but can beprovided through any of the variousforms of ICT- based models, includingthrough BCs.

Micro-finance: Status

148. The self-help group (SHG)-banklinkage programme has emerged as themajor micro-finance programme in thecountry and is being implemented bycommercial banks, RRBs and co-operativebanks. As on March 31, 2009, 4.2 millionSHGs were operating with an outstandingbank credit of Rs.22,680 crore, up by 34per cent over March 31, 2008. During2008-09, banks financed 1.6 million SHGs,

including repeat loans to existing SHGs, tothe tune of Rs.12,254 crore. There were 6.1million savings accounts of SHGs withbanks as on March 31, 2009 with totaldeposits amounting to Rs.5,546 crore.

149. The role of micro-finance institutions(MFIs) in providing financial services to thepoor is growing in importance. The bankingsector has been extending loans to MFIsfor on-lending to SHGs. During 2008-09,bank loans amounting to Rs.3,732 crorewere disbursed to 581 MFIs, increasing thetotal outstanding loans to Rs.5,009 crore to1,915 MFIs as on March 31, 2009.

Priority Sector Lending Certificates(PSLCs): Working Group

150. The Committee on FinancialSector Reforms (Chairman: Dr. RaghuramG. Rajan), inter alia, recommendedintroduction of priority sector lendingcertificates (PSLCs) for purchase by banksfor achieving the priority sector lendingtarget. According to the Committee’srecommendation, PSLCs would be issuedby registered lenders such as MFIs,NBFCs, co-operatives, and registeredmoney lenders for the amount of loansgranted by them to the priority sector, andalso by banks for the amounts in excess oftheir stipulated priority sector lendingrequirements. These certificates could betraded in the open market, and bankshaving shortfall in meeting the prioritysector lending targets could buy suchcertificates and thus meet the prioritysector lending norms. The Committeefurther recommended that in the trading ofPSLCs, the actual loans would continue toremain on the books of the original lender

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unlike in outright purchase of loan assets.However, the buyer bank would show theamount in its priority sector lendingrequirements. The seller of PSLC, if it is abank, will take it off its priority sectorlending requirements even though it willcontinue to carry the loan on its books.

151. Preliminary discussions indicatedthat there are both merits and demerits ofthe proposal. Therefore, it is proposed:

• to constitute a Working Group to examinethe issues involved in the introductionof priority sector lending certificatesand make suitable recommendations.

VI. Regulatory Measures for Commercial Banks

Relaxations in Branch AuthorisationPolicy

152. As announced in the Annual PolicyStatement of April 2009, a Working Group(Chairman: Shri P. Vijaya Bhaskar) wasconstituted to review the extant branchauthorisation policy with a view toproviding greater flexibility to banks foropening branches to enhance bankingpenetration and promote financialinclusion. The Group has since submittedits report. Taking into consideration theGroup’s recommendations, it is proposedto liberalise the extant branch authorisationpolicy for domestic scheduled commercialbanks (other than RRBs) as under:

• Domestic scheduled commercial banks(other than RRBs) will now be free toopen branches in Tier 3 to Tier 6 centresas identified in the Census 2001 (withpopulation up to 50,000) under generalpermission.

• Opening of branches by domesticscheduled commercial banks (otherthan RRBs) in Tier 1 and Tier 2 centres(with population over 50,000) willcontinue to require prior authorisation.

• Banks may plan their branch expansionin Tier 3 to Tier 6 centres in such a

manner that at least one-third of suchbranches are in the underbanked districtsof underbanked States as will be notifiedseparately by the Reserve Bank. Thiswould be one of the criteria in the ReserveBank’s consideration of proposals bydomestic scheduled commercial banks(other than RRBs) to open branches inTier 1 and Tier 2 centres. In consideringsuch proposals, the Reserve Bank would,in addition, take into account banks’performance in financial inclusion,priority sector lending and level ofcustomer service, among others.

Enhancements to the Basel IIFramework

153. In July 2009, the Basel Committeeon Banking Supervision (BCBS) had finalisedenhancements and revisions in certain areasof the Basel II framework. The enhanced/revised guidance of BCBS is contained intheir three documents, viz., Enhancements tothe Basel II Framework; Revisions to theBasel II Market Risk Framework; andGuidelines for Computing Capital Charge forIncremental Risk in the Trading Book. Theseenhancements and revisions are intended tostrengthen the framework and respond tolessons learnt from the financial crisis.

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154. The enhancements and revisionsnow stipulated by BCBS are, however,mostly applicable to advanced approachesof the Basel II framework. Banks in Indiahave implemented standardised/basicapproaches contained in the framework.However, wherever those enhancements andrevisions are applicable to standardised/basicapproaches, it is proposed:

• to issue detailed guidelines as appropriatefor implementation by banks operatingin India by end-November 2009.

Introduction of Duration Gap Analysisfor Asset Liability Management

155. The Reserve Bank had issuedguidelines on asset liability management inFebruary 1999, which, inter alia, coveredaspects relating to interest rate riskmeasurement. These guidelines to banksapproached interest rate risk measurementfrom the ‘earnings perspective’ using thetraditional gap analysis (TGA). To beginwith, the TGA was considered as a suitablemethod to measure interest rate risk. TheReserve Bank had, however, indicated itsintention to shift to modern techniques ofinterest rate risk measurement such asduration gap analysis (DGA), simulationand value-at-risk over a period of time,when banks acquire sufficient expertise andsophistication in this regard. Since bankshave gained considerable experience inimplementation of the TGA and havebecome familiar with the application of theconcept of duration/modified durationwhile applying standardised durationmethod for measurement of interest rate riskin the trading book, this is an opportune timefor banks to adopt the DGA for management

of their interest rate risk. With this move,banks would migrate to the application ofthe ‘economic value perspective’ to interestrate risk management. Accordingly, it isproposed:

• to issue detailed guidelines on the useof DGA for management of interest raterisk by end-November 2009 .

Review of Capital Adequacy Normsfor Take-out Financing

156. At present, the credit conversionfactor (CCF) for off-balance sheet exposureof the take-out financing institution, whichcaptures that institution’s unconditionalcommitment during the period up to thetake-out event, is 100 per cent. The CCFfor conditional take-out has been fixed at alower level of 50 per cent reflecting theuncertainty regarding the take-out event dueto the conditional nature of the agreement.The existing capital adequacy treatment oftake-out financing is in conformity with thecapital adequacy treatment of forward assetpurchases under both Basel I and Basel II.The issue has been reconsidered and it isproposed:

• to allow banks to build up capital fortake-out exposures in a phased manner.

157. Detailed guidelines in this regardare being issued separately.

Commercial Real Estate Exposures

158. In view of large increase in creditto the commercial real estate sector overthe last one year and the extent ofrestructured advances in this sector, itwould be prudent to build cushion against

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likely non-performing assets (NPAs).Accordingly, it is proposed:

• to increase the provisioning requirementfor advances to the commercial realestate sector classified as ‘standardassets’ from the present level of 0.40 percent to 1 per cent.

Review of Adequacy of Loan LossProvisions

159. At present, the provisioningrequirements for NPAs range between 10 percent and 100 per cent of the outstandingamount, depending on the age of the NPAs,the security available and the internal policyof the bank. Since the rates of provisioningstipulated by the Reserve Bank for NPAs arethe minimum and banks can make additionalprovisions subject to a consistent policybased on riskiness of their credit portfolios,it has been observed that there is a wideheterogeneity and variance in the level ofprovisioning coverage ratio across differentbanks. With a view to improving theprovisioning cover and enhancing thesoundness of individual banks, it isproposed:

• to advise banks to augment theirprovisioning cushions consisting ofspecific provisions against NPAs as wellas floating provisions, and ensure thattheir total provisioning coverage ratio,including floating provisions, is not lessthan 70 per cent. Banks should achievethis norm not later than end-September2010.

Banks’ Exposure to NBFCs Engagedin Infrastructure Financing: Reviewof Risk Weights

160. At present, the risk weight forbanks’ exposure to systemically important

non-deposit taking NBFCs (NBFCs-ND-SI)is 100 per cent. However, asset financecompanies (AFCs) within the NBFCs-ND-SIcategory carry a risk weight based on creditratings. As indicated in para 178 in SectionVII of this part, NBFCs engaged in financingof infrastructure would henceforth beclassified in a new category calledinfrastructure NBFCs. Since financing bysuch NBFCs would essentially result in thecreation of physical infrastructure, it isproposed:

• to link the risk weights of banks’exposure to such NBFCs to the creditrating assigned to the NBFC by externalcredit assessment institutions (ECAIs).

Lock-in Period and Minimum Retentionfor Securitisation Exposures

161. To ensure that the originators do notcompromise on due diligence of assetsgenerated for the purpose of securitisation,it was proposed in the Annual PolicyStatement of April 2009 to stipulate aminimum lock-in period for bank loansbefore these were securitised. It was alsoproposed to lay down minimum retentioncriteria for the originators as anothermeasure to achieve the same objective.Accordingly, it is proposed:

• that the minimum lock-in period for alltypes of loans would be one year beforethese can be securitised; and

• that the minimum retention by theoriginators will be 10 per cent of the poolof assets being securitised.

162. The international work, especiallyin the European Union and the USregarding the minimum retention criteria,is still underway. The Reserve Bank will

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issue detailed guidelines on the manner ofcomputation of the one year lock-in periodand other operational details keeping inview the international norms beingdeveloped.

Compensation Practices

163. Compensation practices, especiallyof large financial institutions, were one ofthe factors which contributed to the recentglobal financial crisis. The FSB hasbrought out certain principles for soundcompensation practices. The principles callfor effective governance of compensation,and for compensation to be adjusted for alltypes of risk, to be symmetric with riskoutcomes, and to be sensitive to the timehorizon of risks. These principles, whichhave been endorsed by the G-20, should bethe guiding tenets for devising compensationschemes for all employees in a financialinstitution. The Reserve Bank is workingon the FSB principles for soundcompensation and it is proposed:

• to issue suitable guidelines to privatesector and foreign banks with regard tosound compensation policies.

Liquidity Risk

164. The Annual Policy Statement ofApril 2009 proposed to place the draftcircular on liquidity risk management, asalso the guidance note on “Liquidity RiskManagement” on the Reserve Bank’swebsite by mid-June 2009. This wasdeferred. Keeping in view active discussionsunderway at the global level on liquidityrisk management as the BCBS is also inthe process of enhancing the modalities for

adopting the integrating risk managementsystem, it is now proposed:

• to issue a draft circular reflecting thesechanges by end-December 2009.

Stress Testing

165. The Annual Policy Statement ofApril 2009 proposed upgradation of thestress testing guidelines once BCBSfinalises the paper on ‘Principles for SoundStress Testing Practices and Supervision’.In this context, the guidelines issued tobanks in June 2007 are required to beenhanced in the light of the final paperissued by BCBS and taking into accountinternational work/initiatives in the area ofstress testing, particularly that being doneby the IMF and the FSB. It is proposed:

• to issue guidelines to banks on stresstesting by end-January 2010.

Credit Rating Agencies: Status

166. It was indicated in the AnnualPolicy Statement of April 2009 that theReserve Bank will liaise with the SEBI onthe issue of rating agencies’ adherence toCode of Conduct Fundamentals of theInternational Organisation of SecuritiesCommissions (IOSCO). Accordingly, inorder to review rating agencies’ continuedaccreditation under Basel II, the ReserveBank conducted meetings with CreditRating Information Services of India Ltd.(CRISIL), ICRA Ltd., Credit Analysis andResearch Ltd. (CARE) and Fitch. TheReserve Bank has also initiateddiscussions with the SEBI to assess therating agencies’ compliance with theenhanced Code of Conduct Fundamentalsof the IOSCO.

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VII. Institutional Developments

Payment and Settlement Systems

Guidelines for Pre-paid PaymentInstruments in India

167. As indicated in the Annual PolicyStatement of April 2009, SCBs and non-bankentities, which complied with the eligibilitycriteria, were permitted to issue pre-paidpayment instruments. Furthermore, inAugust 2009, other entities were alsopermitted to issue mobile phone basedsemi-closed system pre-paid instruments fora maximum value of Rs.5,000.

Electronic Payment Systems

168. Between end-March 2009 andend-September 2009, the branch networkof national electronic funds transfer (NEFT)enabled banks increased from 54,200 to60,839 and the RTGS enabled branchesincreased from 55,000 to 60,144. Theaverage number of daily transactionshandled by the RTGS network increasedfrom 80,000 to 90,000.

National Electronic Clearing Service

169. As indicated in the Annual PolicyStatement of April 2009, the volume oftransactions through national electronicclearing service (NECS), introduced inSeptember 2008, is gradually increasing. Asat end-September 2009, 114 banks with30,780 branches have been participating inNECS.

Customer Service at ATMs

170. The Reserve Bank received anumber of complaints from bank customers

regarding debit of their accounts even thoughATMs had not disbursed cash for variousreasons. In order to improve customerservice, the Reserve Bank advised all banksto reimburse to the customers the amountwrongfully debited on account of failed ATMtransactions within a maximum period of 12days from the date of receipt of customercomplaint. In case a bank fails to re-creditthe customer’s account, it is required to paycompensation of Rs.100 per day to theaggrieved customer. The amount ofcompensation is credited to the customer’saccount on the same day the bank creditsthe amount of the failed ATM transaction.

Facility to Use ATMs of other Banks:Rationalisation

171. The Reserve Bank had advised thatcustomers could use the ATMs of otherbanks for cash withdrawal free of chargewith effect from April 1, 2009. This led to aquantum increase in ATM transactions,especially small value cash withdrawaltransactions, which tended to impair theviability of operations. The Indian Banks’Association (IBA), therefore, approached theReserve Bank with suggestions to rationalisethe facility in order to achieve a balancebetween optimising customer convenienceand mitigating operational difficulties.Taking into account all the relevant issues,the Reserve Bank agreed to the IBA’ssuggestions of: (i) extending the access ofATMs of other banks to only customershaving savings bank accounts; (ii) pegginga cap of Rs.10,000 per withdrawal at ATMsof other banks; and (iii) permitting only fivefree transactions per month at ATMs of other

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banks. These instructions came into effectfrom October 15, 2009.

Mobile Payments

172. With the issuance of the operativeguidelines for mobile payments on October8, 2008, the Reserve Bank has so fargranted approval to 32 banks to providemobile banking facilities to their customers.

Cheque Truncation System

173. The Annual Policy Statement ofApril 2009 indicated that the Reserve Bankwill continue to take steps towards extendingthe cheque truncation system (CTS) acrossthe country. In pursuance of this, effectiveJuly 1, 2009, all cheque volumes at NewDelhi migrated to CTS and accordinglymagnetic ink character recognition (MICR)clearing (both at SBI and the Reserve Bank)was discontinued. Furthermore, action toroll-out CTS at Chennai has been initiatedand it is proposed that New Delhi andChennai would act as backup for each other.With effect from July 1, 2009, a fee ofRs.0.50 per instrument each from thepresenting bank and from the paying bankin the CTS has been introduced. Presently,CTS is handling around 6,00,000 instrumentsevery day.

Cash Withdrawal at Point-of-Sale (POS)

174. Cash is predominantly used forsmall value payments and as such there isalways a need for availability of currency.The use of debit cards at point-of-sale(POS) terminals at different merchantestablishments has been steadily on the rise.The number of POS terminals in the countryat the end of August 2009 was 4,87,024.As a further step towards enhancingcustomer convenience in using plastic

cards, cash withdrawals up to Rs.1,000 perday at POS terminals have been allowed forall debit cards issued in India.

The Payment and Settlement SystemsAct, 2007

175. As indicated in the Annual PolicyStatement of April 2009, all paymentsystem providers/operators, includingcredit card issuing companies and entitiesengaged in money transfer activity, requireauthorisation as per the Payment andSettlement Systems Act, 2007. Accordingly,30 payment system service providersproviding service in India have beengranted certificate of authorisation by theReserve Bank by end-September 2009.

Currency Management

176. The High Level Group on CurrencyManagement (Chairperson: Smt UshaThorat) constituted by the Reserve Banksubmitted its Report in August 2009. TheGroup has, inter alia, emphasised theimportance of using modern technology andsecurity systems for stocking, processingand distribution of currency to ensureadequate availability of genuine and cleannotes to the public. With a view toencouraging banks for giving due priorityto the above objective, it is proposed:

• to mandate banks to install note sortingmachines in all their branches in aphased manner in terms of a roadmapto be approved by the Reserve Bank; and

• to have the responsibility of currencymanagement entrusted to a nodal officialin each bank, who shall be a seniorfunctionary at a level not less than thatof a General Manager and who will beaccountable for the obligations cast uponcurrency chests by the Reserve Bank.

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177. Detailed guidelines based on thereport of the Working Group are beingissued separately.

Non-Banking Financial Companies

Classification of NBFCs-ND-SI:Infrastructure Companies

178. NBFCs-ND-SI engaged predominantlyin the infrastructure financing haverepresented to the Reserve Bank that thereshould be a separate category ofinfrastructure financing NBFCs in view ofthe critical role played by them in providingcredit to the infrastructure sector. Currently,the Reserve Bank classifies NBFCs underthree categories, viz., asset financecompanies, loan companies and investmentcompanies. It has now been decided to:

• introduce a fourth category of NBFCsas ‘infrastructure NBFCs’, defined asentities which hold minimum of 75 percent of their total assets for financinginfrastructure projects.

179. Detailed instructions, includingeligibility criteria, are being issued separately.

Repossession of Vehicles by NBFCs

180. The Annual Policy Statement ofApril 2009 had emphasised that NBFCsshould have a built-in repossession clause(in respect of repossession of vehicles) andalso detailed provisions with regard to termsand conditions for ensuring transparency inthe contract/loan agreement with the

borrower which will be legally enforceable.Accordingly, NBFCs were advised thebroad framework in respect of terms andconditions of the contract/loan agreement,viz., (i) notice period before takingpossession; (ii) circumstances under whichthe notice period can be waived; (iii) theprocedure for taking possession of thesecurity; (iv) a provision regarding finalchance to be given to the borrower forrepayment of loan before the sale/auction ofthe property; (v) the procedure for givingrepossession to the borrower; and (vi) theprocedure for sale/auction of the property.Furthermore, NBFCs were urged to makeavailable a copy of such terms and conditionsto the borrowers at the time of sanction/disbursement of loans, which may form akey component of such contracts/loanagreements.

Special Liquidity Facility for EligibleNBFCs-ND-SI

181. The special liquidity facility foreligible NBFCs-ND-SI for meeting thetemporary liquidity mismatches through theIndustrial Development Bank of IndiaStressed Asset Stabilisation Fund (IDBISASF) Trust, which was notified as a specialpurpose vehicle (SPV) for undertaking theoperation, was extended for eligible papersissued by NBFCs up to September 30, 2009.The SPV will cease to make fresh purchasesafter December 31, 2009 and will recoverall dues by March 31, 2010. The facilitywas availed of to the extent of Rs.750 croreand was repaid fully by July 7, 2009.

Mumbai

October 27, 2009