Trying to Understand Monetary Policy in India

In my last post I referred to Ajay Shah’s blog. Ajay is very clear in his views of India’s monetary policy. He highlights the absence of transparency, and argues that objectives and instruments of policy are muddled. I’ll leave readers to go through his arguments directly. I’m still trying to figure out what’s going on. Here are some more excerpts from the RBI governor’s statement:

Money supply growth

“Money supply (M3) increased by 20.5 per cent on a year-on-year basis on July 4, 2008, lower than 21.8 per cent a year ago. On a financial year basis, M3 increased by 3.5 per cent (Rs.1,39,475 crore) during 2008-09 up to July 4, 2008 as compared with the increase of 3.8 per cent (Rs.1,26,058 crore) in the corresponding period of the previous year.”

Interest rates:

“Financial markets reflected the changes in liquidity conditions during the first quarter of 2008-09. The weighted average call money rates rose from 6.11 per cent in April 2008 to 7.75 per cent in June 2008 due to tighter liquidity consequent upon increases in the CRR in April and May 2008 and in the LAF repo rate on June 12, 2008 and June 25, 2008.The call rates started moving upwards from June 12 and reached a level of 9.12 per cent on July 25, 2008.”

“On the lending side, the benchmark prime lending rate (BPLR) of PSBs and private sector banks were placed in the range of 12.75-14.00 per cent and 13.50-17.25 per cent, respectively, in July 2008 as compared with 12.25-13.50 per cent and 13.00-16.50 per cent in March 2008.”

Credit growth:

“The rate of money supply and deposit growth have started to dip in consonance since June, edging towards the trajectory set for 2008-09.The balancing of monetary and liquidity conditions has not, however, impacted the demand for bank credit which has accelerated on a year-on-year basis.In particular, food credit has recorded a turnaround to support the large-scale operations in food procurement by public agencies. While credit to the petroleum sector has risen sizeably due to the funding requirements of oil companies in the context of the escalation in international crude prices, bank credit to other sectors has also picked up, particularly to infrastructure, cement, chemicals, transport operators and professional and other services, reflecting resilient activity in these sectors. On the other hand, bank credit flowing to agriculture, housing, real estate, construction, metal products, textiles, gems and jewellery and engineering has moderated on account of sector-specific factors which have impacted input costs and impeded the flow of credit.”

Business expectations:

“The business expectations index for April-June 2008 declined by 5.4 per cent from its level in January-March, but was marginally higher (by 0.3 per cent) than in the corresponding quarter a year ago. For July-September 2008, nearly half of the respondents expect an improvement in the overall business situation and the outlook for production, order books and capacity utilisation is positive. In continuation of the assessment for the previous quarter, a majority of respondents expect no change in the financial situation, working capital finance requirements, availability of finance and profit margins. Expectations of rise in input costs and selling prices appear to have firmed up. The business expectations index for July-September 2008 is lower by 0.9 per cent than its level in the previous quarter but higher by 0.8 per cent than its level a year ago.”

Here are some questions I was left with after wading through the report (there’s much more than I have excerpted):

1. If interest rates have been raised substantially, and the cash reserve ratio has also been raised — even more, in fact — why is credit growth so strong? There is something in the policy statement about banks lending too much. Why is this the case? Are real interest rates simply too low? Lending rates are above the current inflation rate, but not by much. Business expectations are moderating and the growth in the industrial production index is way down. Is it that public sector agencies are pumping up demand for credit (see one of the excerpts above). I am left with the feeling that no one really understands what drives credit and investment in the Indian economy. Or is it simply me?

2. Inflation expectations are highlighted in the policy statement. They are mentioned about 16 times in the context of India (excluding references to the global inflation situation). Several times the need to anchor inflation expectations is mentioned. But I could find no numbers for these inflation expectations, or any indication of how they are formed, and what factors will lead to their moderation.

3. Ajay Shah argues that the RBI’s attempts to manage the exchange rate have contributed to inflation. The RBI’s review completely ignores any possible connection between the exchange rate and inflation, except to note without comment that additions to reserves have increased base money. Do we have any empirical evidence for the link between the RBI’s operations in the foreign exchange market and domestic inflation?

I’d love some pointers to solid empirical work on these issues, either within the RBI or by academics.

3 Responses to "Trying to Understand Monetary Policy in India"

  1. Anonymous   August 1, 2008 at 5:13 am

    //I’d love some pointers to solid empirical work on these issues, either within the RBI or by academics.//Good Luck..

  2.   August 26, 2008 at 12:40 pm

    Is it possible that the credit growth is driven primarily by the Government of India? It seems that they have been big borrowers from RBI in order to fund the oil subsidies, fertilizer subsidies, govt pay hikes, welfare schemes, etc. Also, RBI had opened a direct lending facility to Indian Oil Corporation. Maybe that could have added to the credit growth as well.I think consumers and corporations are tapped out and have retrenched. The current wave of credit growth is coming from Indian government institutions. This will definitely lead to higher inflation and devaluation of the INR.My $0.02Dwarkanath

  3. Anonymous   November 3, 2008 at 11:38 pm

    I am almost illitrate about the fiscal and monetary policies.plz tell me about them