The Efficacy of Monetary Transmission

Updated: Aug 26 2002, 05:30am hrs
What is the prime policy target of a central bank We may not be far off the mark if we say that it should be growth with stability.

But on many an occasion, we see that the growth factor seems to be made subservient to the stability objective; stability defined as external stability and internal stability.

Granted that without stability on the exchange front and monetary fronts, growth can be seriously jeopardised. But an ultra-cautious attitude can prove counter-productive tp growth.

A classic example was the excessive reserve money squeeze of the mid-90s.

The experience of the last two years has again thrown up the question on whether the Reserve Bank of India (RBI) acted extra cautiously. 1995-96 and 2000-02 cannot of course be directly compared.

This momentum of market interest rates was further accentuated by the recent economic slowdown. The accompanying credit migration has, however, kept credit spreads very high.

Much of the drop in rates has not accrued to entities other than the government and blue-chip corporates. Banks have been reluctant to reduce deposit rates as they had to compete with the administered rates and also reluctant to reduce lending rates since most of them work on a cost plus basis and with a high rate of credit defaults and increasingly tighter capital adequacy norms.

But are interest rate linkages so strong that a reduction in interest rates would cause an economic upturn If they are not, how would reducing interest rates help generating growth impulses

Are not consumers in India predominantly averse to borrowing And are not interest costs a small percentage of total expenses of a manufacturer to be of much significance

In as much as the fall in interest rates has been neither wide spread nor significant enough for many a borrower, the proposition that lower interest rates do not help growth is yet to be tested if not questionable.

It is the not very highly rated entities that tend to leverage more. In case of consumer demand, demographic preferences seem to be shifting fast.

If this alternate proposition is accepted, then a widespread reduction in interest rates should help all at-margin-investing.

What also seems to be lacking is credit arbitraging. The entire financial system had been chasing credit quality and eschewing all credit risk.

This is either because of the previous credit default experience, capital adequacy norms or because of investor expectations (for funds).

While this was an opportunity for some, from a macro-economic perspective, absence of credit arbitrageurs curtails the capabilities of monetary transmission mechanism.

It is in this context that one has to see whether the monetary authorities have done enough to propel demand.

To RBIs credit, the monetary stance has been maintained, and to a large extent, led to a sustained reduction in market yields. But till late 2001, RBI resisted cuts in key rates.

Inflation should not have been a worry and in fact, a higher inflation is possibly required to propel growth, as suggested by RBI economists!

However, when the rate cuts did come, they were perhaps not large enough (except in CRR wherein the large cuts came as part of overhauling of the reserve maintaining system).

The repos rate (closest in comparison to say the Fed Funds rate) was hardly touched and when it came in early 2002, there was already talk of a global cyclical trough so that further rate cuts would seem out of place and adventurous.

The auction system of repos rate also creates an anomaly in the monetary transmission. RBI has to await bids at lower repos rate to cut this rate.

Since there are very few bids, it is in the interest of such lenders to keep the bids at higher (previous) levels as long as the same is accepted.

When the rate cut did come, it came not through the auction process, but by RBI indication and more recently by RBI rejecting bids at the previous rate.

Automatic sterlisation was happening at repos rate. So if RBI wanted an easy money policy, it certainly did not transmit fully to the system because of the high repos rate.

A casual glance at the movement of US-Indian short-term yield differentials over past two years amplifies this anomaly. The relatively high repos rate also explains the collapse of the yield curve in very easy markets.

Sharply lower spreads across tenors in easy markets have nothing to do with inflationary expectations nor do they signal any structural ramifications.

It simply suggested that participants are taking an increasingly higher risk to earn some carry since the short end of the yield curve is held up. When it came to Bank Rate, the extent of the cuts seems moderate as compared to cuts by other central banks.

In the meanwhile, the debt market moved far ahead of RBI. Possibly, it is a worry for the authorities that when markets are already way ahead of policy, subsequent policy action would be seen as more than confirmatory and propel further expectations taking the markets to unsustainable levels.

It is perhaps this worry that prompted a late and subdued action from RBI. In the absence of sharp cuts in the Bank Rate, the banking system continued to charge high rates to borrowers and offer high rates to depositors. What was perhaps required was a stronger action on Bank Rate with simultaneous intervention in the yield curve to moderate expectations on market yields.

All this perhaps lends credence to the proposition that money supply was not transmitted to at-margin-assets albeit, unwittingly. The recent credit policy did seem to recognise some of these pitfalls in transmission.

The RBI expressed concerns on lack of credit flows to commercial sector, attempted to partly de-link liquidity and long-term yields, questioned the term-structure and restated the policy objective as alignment of various rates in a narrow band.

Taking a cue from the policy and the recent repos rate cut, there has been a marked move towards compression of corporate spreads and steeper yield curve with shorter rates dropping more; but we have to wait and watch whether this new trend will sustain.

In taking a stand on stability versus growth, we have not touched upon one of the major concerns of authorities: the fiscal issue and the degrees of freedom it takes away from monetary policy and makes it willy nilly defensive.

The author works with IL&FS Asset Management Co Ltd. The views expressed in this article are his own and not necessarily those of the organisation