The Hindu Business Line : Complexities of monetary policy-making

Contrary to common belief, monetary policy-making is more difficult than devising the fiscal plan. For, in open economies, the monetary policy has to interface with the uncertain market behaviour and expectations. A. Vasudevan looks at aspect s of monetary policy making, especially in the Indian context with limited availability of empirical literature on the subject.

THERE ARE many who believe that Monetary Policy making is much less complex than Fiscal Policy making. Their perception is based on the arguments that the objectives of the monetary policy are definable and its instruments few. This perception, however, does not square with the realities. For, unlike other areas, monetary policy in open economies has to interface with the uncertain market behaviour and expectations.

Uncertainties arise for several reasons. Market participants are several — individuals, financial institutions including banks, governments, domestic private corporate sector and foreign investors. They possess diverse information sets of divergent quality. They have some common macro data but often inadequate micro-level data. Besides, uncertainties about the developments in partner countries and policy uncertainties both at home and partner countries can seriously constrain expectations formation. Finally, there are uncertainties about the efficiency of those associated with implementing the policies. Inefficient governance in its broad sense and gaps in financial infrastructure could act as constraints to expectations.

Even if one were to assume away the uncertainties, there would still be the complex but a critical problem of knowing which of the policies would have the desired impact on the desired outcomes and how the impact is transmitted through the economy. Much of the empirical literature on the transmission channels of monetary policy has emanated from the developed economies such as the US and the UK. The theories developed out of these experiences are converted into hypotheses for testing in developing economies.

Interestingly enough, the empirical literature on the subject in the case of India is limited. In fact there was only one published piece on the subject till almost the 1990s (see the article written by the present author along with K. A. Menon in 1978 in the author's edited volume, Money and Banking, Academic Foundation, New Delhi, 2003). It tested the validity of different channels — the money supply, the rate of interest, wealth, and credit rationing — taking the annual data for the period 1956-57 through 1976-77. It reported eclectic results.

Subsequent efforts were so few that they could be counted on fingertips (in fact, this author could locate only two articles and two Ph.D. theses on the subject). Some articles, however, centred on issues that are broadly germane to an understanding of the transmission mechanism such as inflation targeting, asset prices, changes in bank credit in the aggregate and in disaggregate form along with changes in output, exchange rate volatility and responses of monetary policy to changes in commodity prices and exchange rates.

Almost all the empirical analyses take time series data on annual basis and conduct tests by using either the regression technique or the more recent co-integration method. Taking time series information without considering the content of data and the shifts in the economic policy regimes would introduce distortions in analysis. Let us first deal with the shifts in economic policy regimes.

It is well recognised, for example, that administered interest rate regime or credit allocation devices would give results that would be divergent from the position that interest rate flexibility would provide and the freedom of choice about credit disbursal would give. The times series data that combines the administered regime with market related regime would thus be technically flawed. Stretching this reasoning, one needs to also check whether the market-oriented regime has been set up at one go — the `big bang'— or in different well identifiable stages. In case the regime shift is not of a big bang category, one needs to be doubly sure that the data on all the variables reflect true market orientation.

In the case of India, the economic policy regime shifted from the middle of 1991 but the shift in the financial policy regime was only from end 1992 and that too in measured steps. For example, interest rates were administered till 1994 and whatever flexibility was achieved in this area was also not total. Exchange rates were `market related' only from March 1993. The external current account convertibility took place in August 1994 and here too there were some exceptions constraining the repatriation of dollars from current incomes other than interest income by non-residents from India. These constraints existed for three years.

The Central Government securities market was brought under a system of auctions from 1993-94. Till almost the end of the 1990s, State government securities were sold in the primary market on coupon rate basis. The ceiling rate on inter-bank call rates was removed in early 1990 but the call money market continues to have unequal number of lenders and borrowers. The statutory liquidity ratio (SLR) was brought down in stages from 38.5 per cent at the end of September 1990 to the statutorily given minimum of 25 per cent only by end of October 1997.

The cash reserve ratio (CRR) was in double-digit level till almost March 1999 notwithstanding the fact that the statutory minimum is only 3 per cent. The Bank Rate that was 11 per cent in early July 1991 came down to single digit only in October 1997.

The above instances show that the regime shift was not instantaneous, generating market distortions and weakening of the effectiveness of transmission channels. Let us now take up the issue of the content of data. No empirical work on transmission channels for developing economies can ignore the quantity variables such as money supply and credit and net foreign exchange assets of the banking system. It is here some apprehensions arise at this stage about the use of transmission mechanism. It is six years since the third working group report on money supply was published and as yet there are no signs of implementing its recommendations and giving up the present (1977) series.

In the last three years, the rates of growth in broad money (M3), other banks' credit to the commercial sector (BCCS), net foreign exchange assets of the banking sector (NFA), and net non-monetary liabilities of the banking sector (NML) in the 1977 and 1998 series differed substantially (see Table). The NFA and M3 grew at a consistently higher rate while the growth in BCCS and NMF was consistently lower as per the 1998 series than what the 1977 series reveal. (BCCS and NML of the 1998 series were reworked to make them comparable with the earlier ones).

If this trend of divergence continues in the current fiscal year, then no one would be able to make any meaningful monetary analysis for purposes of policy. Empirical analysis based on yearly data would be of no use given the uncertainties. It would be more useful to conduct analysis based on more frequent information. Output data can be got only on quarterly basis from 1996-97. Quarterly observations thus would be about 30, a number that may not be sufficient if cointegration method with lag structure is used, for gaining robust results.

The Reserve Bank of India, however, should do such technical exercises with caveats about the regime shifts without expecting any robust results. Till one gets somewhat reliable results, monetary policy-makers would have to continue to rely on judgments that would be perceived as credible by market participants.

(The author, formerly Executive Director of the Reserve Bank of India can be reached at asurivasudevan@hotmail.com)

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