On 27th November 2015, Meghnad Desai Academy of Economics hosted Dr. Mridul Saggar, Advisor, International Department, Reserve Bank of India (RBI) to give a lecture on Monetary Transmission in India. Dr. Saggar began the talk by giving a brief history of central banks and monetary policy actions, remarking that “fiat money” has been in existence since 1080 AD, and yet the economy was functioning properly with no monetary policy or central banks for years. The need for central bank arose because economies are becoming very complex, and integrating more and more with the world. He then explained the basic economics concepts that are useful in understanding monetary transmission, and explained why the monetary transmission in weak in India.
To put simply, monetary transmission is the path through which a change in monetary variables (by the central bank) affects the final outcome of growth and inflation. There are various channels of monetary transmission, the most widely quoted one being the interest rate channel. The channel begins with a change in the exogenous monetary variable – money supply. Increasing the money supply would lead to a reduction in interest rate and real interest rate. This would in-turn boost investment, consumption, thereby increasing output. The other channels of monetary transmission are: Exchange rate channel, asset price channel, balance sheet channel or credit channel, and bank lending channel.
All the aforementioned channels are supposed to work smoothly in theory; however this is not the case in practice – for different countries, some channels work and some do not. In India, monetary transmission is rather weak compared to other countries. This is because monetary transmission is limited which affects its efficacy. Some of these impediments are:
Fiscal dominance: Fiscal dominance is a situation where the central bank gives up its control over the quantity of money and over inflation to prevent the government from defaulting on its public debt. In India, this was the case until the last few years. Every fiscal deficit ran by the government before the 1990s was monetized by the RBI. This made it difficult to control inflation. Several changes were made to improve monetary independence, the biggest one being the introduction of the Fiscal Responsibility and Budget Management (FRBM) Act in 2003. However, even though fiscal dominance in India has been reduced over time, it has not disappeared because the fiscal deficits have increased sizeably over time. Also, the RBI has to deal with the presence of administered interest rates (to ensure subsidies) for various saving schemes. Such interest rate subventions, and tax distortions in the market also affect monetary transmission.
Presence of large informal sector: A large part of India’s market in unregulated to the presence of informal sector. The 70th NSSO survey showed that informal sector provides 93% of employment (excluding agriculture) and contributes to 50% of our GDP. Moreover, it also accounts for 44% of non-institutional credit in rural households. Another barrier to smooth monetary transmission is the rate of interest charged by microfinance institutions (that are not a part of commercial banks) which range from 8% to 36%. Therefore, a change in interest rate by the RBI has no effect on the interest rates of these institutions.
Bank behaviour and credit market frictions: Banks in India provide three kind of accounts – current account, savings account, and term deposit accounts, out of which only the first two are sensitive to interest rate movements. An RBI survey found that 64.5% of all deposits were term deposits, which means that a large proportion of deposits are not interest rate sensitive. Furthermore, our banking sector is not sufficiently competitive – 70% of assets are held by public sector banks. Finally, some lending rates like the corporate lending rate respond faster to a change in monetary variable than others.
Other factors that impede monetary transmission include an increase in share of non-banking financial companies, high inflation (India’s inflation was around 10% for 6 years!) which poses various risks to the economy, and that RBI was under Liquidity Adjustment Facility (LAF) for a long time.
Dr. Saggar concluded the lecture by explaining two recent and important changes in the monetary policy. First, RBI moved from monetary-targeting to inflation-targeting to ensure that monetary policy was effective in achieving the objective of price stability after years of high inflation to avoid any macroeconomic instability. Second, RBI recently switched from using Wholesale Price Index (WPI) to Consumer Price Index (CPI) like all the major economies of the world. This was because RBI introduced a new CPI series which was statistically better-suited and relevant for monetary policy targeting.
At the end of the lecture, Dr. Saggar took a vote on what the RBI’s next decision should be regarding the policy rate (which will be revealed on 1st December 2015). The vote was almost equally split between leaving the policy rate unchanged and cutting the policy rate again.
Date(s) - 27/11/2015
11:00 am - 2:00 pm