Asymmetry in monetary policy transmission in India

Transmission troubles

Consider this: An annual review of the Indian economy by the IMF (International Monetary Fund) released last month reported how a repo cut announced by the Reserve Bank of India in January this year is likely to pave way for lower bank lending rates only in September 2017.

What’s more, certain studies have indicated that monetary policy in India impacts output with a lag of about 2 to 3 quarters and WPI headline inflation with a lag of about 3 to 4 quarters.

 

Caught in transmission

The long, variable and uncertain time lags in the process of money policy transmission begs the question: Does India’s monetary policy transmission mechanism leaves a lot to be desired owing to several loopholes including, but not limited to, the inordinate amount of time a repo cut leads to a lending rate cut?

Critics further argue that the studies highlight a larger issue which warrants greater scrutiny- the effectiveness of the monetary policy arrangement between the government and the RBI.

The objectives

Monetary policy transmission in India is aimed at achieving several parameters, some of which are listed below:

●      Ensure price stability

●      Expansion of bank credit 

●      Boost economic output (exports)

●      Facilitate commerce

●      Rein in inflation

Below is a list of channels of monetary policy transmission in India

Market prices	Market quantities
Interest rates	Money supply
Exchange rates	Credit aggregates
Yields	Government bonds

The ‘interest’ factor

Given that India, by and large, is a bank-dominated economy (notwithstanding the growth of equity and debt markets), several studies have indicated that interest rates are one of the strongest channels of policy transmission.

Asymmetry in policy transmission 

The aforementioned IMF report examined how pass-through to deposit and lending rates is slower in India. The report also stated that the deposit rate adjusts more quickly to monetary policy changes than the lending rate.

Banks find it tricky to cut lending rates following policy rate cuts because the cost of deposits does not adjust quickly by virtue of the fixed nature of deposit contracts. On the contrary, banks can raise lending rates, since loans can be re-priced quickly.

There is a view that small banks are more receptive to contractionary monetary policy shocks compared to big banks. Given that big banks have a large resource base including income from stock and foreign exchange markets, they are, to some extent, better equipped to deal with liquidity crunch.

Intriguingly, monetary transmission mechanism in India, is often referred to many as a ‘black box’ since many channels (interest rates, bank lending and asset prices among others) can influence the final objectives.

The complex network of financial markets and transmission lags lead to uncertainty with policy makers faced with the daunting challenge of assessing the actual impact of policy decisions on macroeconomic aggregates and economic output.

Policy decisions of the RBI to transmit through the money market to bond and asset markets (which in turn, influence savings and investment patterns) and from financial markets to labour markets (as reflected in aggregate output.)

Given that monetary policy works via financial markets (by means of interest rates or liquidity), transmission, by and large, depends on the sophistication of domestic financial markets in addition to financial integration with the real economy. Also, exchange rate regimes may influence the pass-through of external shocks on the domestic market. It has also been observed that the speed of pass-through to asset prices depends on volatility in money markets and balance sheets of banks among other factors.

End to end transmission

There is a view that monetary transmission in India is more effective in times of less liquidity i.e, the pass-through of policy rates is higher during tight monetary policy cycle owing to transmission lags. It is, therefore, argued that there is asymmetry in the transmission of policy rate changes between the surplus and deficit liquidity conditions.  While changes in policy rates are quickly reflected in money market rates and government bond yields, there is a certain degree of inflexibility exhibited by banks when it comes to lending and deposits rates.

The introduction of the Liquidity Adjustment Facility (LAF) as an operating procedure for monetary policy in the post-reform period (2000) is generally considered an important milestone. Experts believe there have been significant changes in the post-LAF period such as a marked importance of interest rate, asset prices and exchange rate channels in influencing monetary policy transmission.