Impact of Monetary Policy on Indian Industry

INTRODUCTION

Monetary Policy is essentially a Monetary Policy is essentially a programme of action undertaken by the programme of action undertaken by the Monetary Authorities, generally the Monetary Authorities, generally the Central Bank, to control and regulate the Central Bank, to control and regulate the supply of money with the public and the supply of money with the public and the flow of credit with a view to achieving flow of credit with a view to achieving pre-determined macro-economic goals.

At the time of inflation monetary policy seeks to contract aggregate spending by seeks to contract aggregate spending by tightening the money supply or raising tightening the money supply or raising the rate of return.

OBJECTIVES

To achieve price stability by controlling inflation and deflation.

To promote and encourage economic growth in the economy.

To ensure the economic stability at full employment or potential level of output.

SCOPE OF MONETARY POLICY

The scope of monetary policy depends on two factors:–

1. Level of Monetization of the Economy – In this all economic transactions are carried out In this all economic transactions are carried out with money as a medium of exchange. This is with money as a medium of exchange. This is done by changing the supply of and demands for done by changing the supply of and demand for money and the general price level. It is capable money and the general price level. It is capable of affecting all economics activities such as of affecting all economics activities such as Production, Consumption, Savings, Investment Production, Consumption, Savings, and Investment etc.

2. Level of Development of the Capital Market –

Some instruments of Monetary Policy are work through capital market such as Cash Reserve Ratio (CRR) etc. When capital market is fairly developed then the Monetary Policy effects the developed economies.

OPEN MARKET OPERATIONS

The open market operations is sale and purchase of government securities and Treasury Bills by the

central bank of the country.

When the central bank decides to pump money into circulation, it buys back the government securities, bills and bonds.

When it decides to reduce money in circulation it sells the government bonds and securities.

The central bank carries out its open market operations through the commercial banks.

DISCOUNT RATE OR BANK RATE POLICY

Discount rate or bank rate is the rate at which central bank rediscounts the bills of exchange presented by the commercial bank.

The central bank can change this rate increase or decrease depending on whether it wants to expand or reduce the flow of credit from the commercial bank.

WORKING OF THE DISCOUNT RATE POLICY

A rise in the discount rate reduces the net worth of the government bonds against which commercial banks borrow funds from the central bank. This reduces commercial banks to borrow from the central bank.

When the central bank raises its discount rate, commercial banks raise their discount rate too. Rise in the discount rate raises the cost of bank credit which discourages business firms to get their bill of exchange discounted.

CASH RATE RATIO

The cash reserve ratio is the percentage of total deposits which commercial banks are required to

maintain in the form of cash reserve with the central bank.

The objective of cash reserve is to prevent shortage of cash for meeting the cash demand by the depositors.

By changing the CRR, the central bank can change the money supply overnight.

When economic conditions demand a contractionary monetary policy, the central bank raises the CRR. And when economic conditions demand monetary expansion, the central bank cuts down the CRR.

STATUTORY LIQUIDITY REQUIREMENT

In India, the RBI has imposed another reserve requirement in addition to CRR. It is called statutory liquidity requirement.

The SLR is the proportion of the total deposits which commercial banks are statutorily required to maintain in the form of liquid assets in addition to cash reserve ratio.

CREDIT RATIONING

When there is a shortage of institutional credit available for the business sector, the large and financially strong sectors or industries tend to capture the lion’s share in the total institutional credit.

As a result the priority sectors and essential are of necessary funds.

Below two measures are generally adopted:

Imposition of upper limits on the credit available to large industries and firms.

Charging a higher or progressive interest rate on the bank loans beyond a certain limit.

CHANGE IN LENDING MARGINS

The banks provide loans only up to certain percentage of the value of the mortgaged property.

The gap between the value of the mortgaged property and amount advanced is called Lending Margin.

The central bank is empowered to increase the lending margin with a view to decrease the bank credit.

MORAL SUASION

The moral suasion is a method of persuading and convincing the commercial banks to advance credit in overall economic interest of the country.

Under this method the central bank writes letter to hold meetings with the banks on money credit matters.

EXPANSIONARY POLICY / CONTRACTIONARY POLICY

An Expansionary Policy increases the total supply of money in the economy while a Contractionary Policy decreases the total money Supply into the market.

Expansionary policy is traditionally used to combat a recession by lowering interest’s rates.

Lowered interest rates means lower cost of credit which induces people to borrow and spend thereby providing steam to various industries and kick start a slowing economy.

A Contractionary Policy results in increasing interest rates to combat inflation.

An Economy growing in an uninhibited manner leads to inflation.

Hence increasing interest rates increase the cost of credit thereby making people borrow less.

Due to lesser borrowing the amount of money in the system reduces which in turn brings down the inflation.

A Contractionary Policy is also known as TIGHT POLICY as it tightens the flow of money in order to contain Inflationary forces.

INCREASE OR DECREASE THE LENDING RATES

The RBI makes an adjustment in its lending rate (Repo Rates) in order to influence the cost of credit. Thereby discouraging borrowing and hence reduces brings reduction in the system.

RBI

BANK

Flow of Money Leading to reduced liquidity

By increasing interest rates

Whenever the liquid in the system increases, the RBI intervenes to stabilize the system.

The Central Bank does this by issuing fresh bonds and treasury bills in open market. This tool was extensively used at the time when dollar inflows into our economy were very high resulting in rupee appreciating. In order to stabilize the exchange rates, RBI first bought additional dollars thereby stabilizing the rate exchange.

RBI Freshly issued Bonds/ T- Bill Open market

Open market

CRR

By increasing the CRR, the RBI decreases the lending capacity of the bank to the extent of the increase in the ratio increase in the ratio.

E.g. of the CRR is increased from 7.5% to 8.5% the banks were deprived of lending to the extent of 75 basis points of their deposit value.

MONETARY POLICY OF INDIA – OVERVIEW

Historically, the Monetary Policy is announced twice a year April-September and (October-March).

The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy.

The Monetary policy determines the supply of money in the economy and the rate of interest charged by banks. The policy also contains an economic overview and provides future forecasts.

The Reserve Bank of India is responsible for formulating and implementing Monetary Policy.

The Monetary Policy aims to maintain price stability, full employment and economic growth.

Emphasis on these objectives have been changing time to time depending on prevailing circumstances.

For explanation of monetary policy, the whole period has been divided into 4 sub periods:

Monetary policy of controlled expansion (1951 to 1972)1972)

Monetary Policy during Pre Reform period (1972 to 1991)to 1991)

Monetary Policy in the Post-Reforms (1991 to 1996)1996)

Easing of Monetary policy since Nov 1996

MONETARY POLICY OF INDIA

Monetary policy of controlled expansion (1951 to 1972)

To regulate the expansion of money supply and bank credit to promote growth.

To restrict the excessive supply of credit to the private sector so as to control inflationary pressures.

Following steps were taken:

Changes in Bank Rate from 3% in 1951 to 6% in 1965 and it remained the same till 1971.

Changes in SLR from 20% in 1956 to 28% in 1971

Select Credit Control: In order to reduce the credit or bank loans against essential commodities, margin was increased.

As a result of the above changes, the supply of money increased from 3.4% (1951 to 1956) to 9.1 (1961 to 1965).

Monetary Policy during Pre Reform period (1972 to 1991)

Also known as the Tight Monetary policy: Price situation worsened during 1972 to 1974. Following Monetary Policy was adopted in 70’s and 80’s which were mainly concerned with the task neutralizing the impact of fiscal deficit and inflationary pressure.

Changes in CRR to the legally maximum limit of 25%

Changes in SLR also to the maximum limit to 38.5%

Monetary Policy in the Post-Reforms – 1991 to 1996

The year 1991-1992 saw a fundamental change in the institutional framework in setting the objective of monetary policy. It had twin objectives which were Price stability and economic growth. Following instruments were used:

Continuing the same maximum CRR and SLR of 25% and 38.5%, mopped up bank deposits to the extent of 63.5%.

In order to ensure profitability of banks, Monetary Reforms Committee headed by late Prof. S Chakravarty, Reforms Committee headed by late Prof. S Chakravarty, recommended raising of interest rate on Government recommended raising of interest rate on Government Securities which activated Open Market Operations (OMO).

Bank rate was raised from 10% in Apr 1991 to 12% in Oct 1991 to control the inflationary pressures.

Easing of Monetary policy since Nov 1996

In 1996-97, the rate of inflation sharply declined. In the later half 1996-97, industrial recession ripped the Indian economy. To encourage the economic growth and to tackle the recessionary trend, the RBI growth and to tackle the recessionary trend, the RBI eased its monetary policy.

Introduction of Repo rate- Repo rate increased from 3% in 1998 to 6.5% in 2005. This instrument was 3% in 1998 to 6.5% in 2005. This instrument was consistently used in the monitory policy as a result of rapid industrial growth during 2005-06. In the current monetary policy, the Repo rate was cut from current monetary policy, the Repo rate was cut from 5.00% to 4.75%.

Reverse Repo rate – Through RRR, the RBI mops up liquidity from the banking system. In the current monetary policy, the Repo rate was cut from 3.50% to 3.25%.

Flow of credit to Agriculture – The flow of credit to agriculture has increased from 34,013 (9.2% of overall credit) in 2009 (Rs. in crore).

Reduction in Cash Reserve Ratio – The CRR which was at 15% until 1995 gradually reduced to 5% in 2005. The CRR remained unchanged in the current monetary policy.

Lowering Bank rate – The Bank rate was gradually reduced from 12% in 1997 to 6% in 2003. Since then the Bank Rate from 12% in 1997 to 6% in 2003. Since then the Bank Rate has remained unchanged to 6%.

Review of 2009/10 Monetary policy

The Policy Review projects GDP growth at 6% this FY due to slackening private consumption and investment demand.

The RBI set its inflation projection for March 10 at 4% (currently at -1.21%). The RBI also projects the CPI to come down into the single digit zone.

Assurance of a non-disruptive borrowing in 2009-10. Recently, the Government increased the borrowing plan from Rs. 2.41 lakh crore to 2.99 Lakh crore because of ample liquidity in the market due to slow credit growth.

The fiscal stimulus packages of the Government and monetary easing and regulatory action of the Reserve Bank have helped to arrest the moderation in growth and keep our financial markets functioning normally.

RBI’s Indicative Projections

2009-2010

(Actual Numbers)

2010-2011

(April 2010 policy targets)

GDP

7.2

8

(with an upward bias)

Inflation

(Based on WPI for March end)

9.9

5.5

Money Supply

(March end)

17.3

17

Credit

(March end)

17

20

Deposit

(March end)

17.1

18

GROWTH

RBI’s revised growth rate is 8% with an upward bias as the indian economy is on recovery path.

Growth in industrial sector and service sector are expected to continue. The export and import sector has also registered a strong growth.

INFLATION

Inflation is projected to be at 5.5% for FY 2010-11. As per RBI inflation is no longer driven by supply side factors alone.

Overall demand pressures on inflation are also beginning to show signs, pushing RBI to increase rates even before the official policy of 2010.

MONETARY MEASURES

The Bank rate has been retained at 6 %.

The repo rate is now 5.25% which has 5% in 2009-2010.

The reverse repo has increased from 3.5% to 3.75%.

The cash reserve ratio of scheduled bank has increased from 5.75% to 6%.

The expected outcomes of the actions are:

Inflation will be contained and inflationary expectations will be anchored.

The recovery process will be sustained.

Government borrowing requirements and the private credit demand will be met.

Policy instruments will be further aligned in a manner consistent with the evolving state of the economy.

IMPACT OF THE OUTCOMES

Growth with stability

The average growth rate of the Indian economy over a period of 25 years since 1980-81 has been impressive at about 6.0 per cent, which is a significant improvement over the previous three decades, when the annual growth rate was only 3.5 per cent. Over the last four years during 2003-07, the Indian economy has entered a high growth phase, averaging 8.6 per cent per annum. The acceleration of growth during this period has been accompanied by a moderation in volatility, especially in industry and services sectors.

An important characteristic of the high growth phase of over a quarter of century is resilience to shocks and considerable degree of stability. We did witness one serious balance of payments crisis triggered largely by the Gulf war in the early 1990s. Credible macroeconomic, structural and stabilization programme was undertaken in the wake of the crisis. The Indian economy in later years could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, the Russian crisis during 1997-98, sanction like situation in post-Pokhran scenario, and border conflict during May-June 1999. Seen in this context, this robust macroeconomic performance, in the face of recent oil as well as food price shocks, demonstrates the vibrancy and resilience of the Indian economy.

The Reserve Bank projects a real GDP growth at around 8.5 per cent during 2007-08, barring domestic and external shocks.

Poverty and unemployment

The sustained economic growth since the early 1990s has also been associated with noticeable reduction in poverty. The proportion of people living below the poverty line (based on uniform recall period) declined from 36 per cent in 1993-94 to 27.8 per cent in 2004-05. There is also some evidence of pick-up in employment growth from 1.57 per cent per annum (1993-94 to 1999-2000) to 2.48 per cent (1999-2000 to 2004-05).

Consumption and investment demand

India’s growth in recent years has been mainly driven by domestic consumption, contributing on an average to almost two-thirds of the overall demand, while investment and export demand are also accelerating. Almost one-half of the incremental growth in real GDP during 2006-07 was on account of final consumption demand, while around 42 per cent was on account of the rise in real gross fixed capital formation. The investment boom has come from the creation of fixed assets and this phenomenon has been most pronounced in the private corporate sector, although fixed investment in the public sector also picked up in this period. According to an estimate by the Prime Minister’s Economic Advisory Council, the investment rate (provisional) crossed 35 per cent in 2006-07 from 33.8 per cent in 2005-06.

A reasonable degree of price stability

High growth in the last four years has been accompanied by a moderation of inflation. The headline inflation rate, in terms of the wholesale price index, has declined from an average of 11.0 per cent during 1990-95 to 5.3 per cent during 1995-2000 and to 4.9 per cent during 2003-07. The trending down of inflation has been associated with a significant reduction in inflation volatility which is indicative of well-anchored inflation expectations, despite the shocks of varied nature. Although, inflation based on the wholesale price index (WPI) initially rose to above 6.0 per cent in early April 2007 it eased to 3.79 per cent by August 25, 2007. Pre-emptive monetary measures since mid-2004, accompanied by fiscal and supply-side measures, have helped in containing inflation in India.

The policy preference for the period ahead is strongly in favour of price stability and well-anchored inflation expectations with the endeavour being to contain inflation close to 5.0 per cent in 2007-08 and in the range of 4.0-4.5 per cent over the medium-term. Monetary policy in India would continue to be vigilant and pro-active in the context of any accentuation of global uncertainties that pose threats to growth and stability in the domestic economy.

Improved fiscal performance

Yet another positive outcome of developments in recent years is the marked improvement in the health of Government finances. The fiscal management in the country has significantly improved consistent with targeted reduction in fiscal deficit indicators after the adoption of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 by the Central Government. The finances of the State Governments have also exhibited significant improvement since 2003-04 guided by the Fiscal Responsibility Legislations (FRLs).

With gross fiscal deficit of the Central Government budgeted at 3.3 per cent of GDP in 2007-08, the FRBM target of 3.0 per cent by 2008-09 appears feasible. The revenue deficit is budgeted at 1.5 per cent of GDP for 2007-08; the FRBM path envisages elimination of revenue deficit in 2008-09.

External sector

India’s linkages with the global economy are getting stronger, underpinned by the growing openness of the economy and the two way movement in financial flows. Merchandise exports have been growing at an average rate of around 25 per cent during the last four years, with a steady increase in global market share, reflecting the competitiveness of the Indian industry. Structural shifts in services exports, led by software and other business services, and remittances have imparted stability and strength to India’s balance of payments. The net invisible surplus has offset a significant part of the expanding trade deficit and helped to contain the current account deficit to an average of one per cent of GDP since the early 1990s. Gross current receipts (merchandise exports and invisible receipts) and gross current payments (merchandise imports and invisible payments) taken together, at present, constitute more than one half of GDP, highlighting the significant degree of integration of the Indian economy with the global economy.

Greater integration into the global economy has enabled the Indian corporates to access high-quality imports from abroad and also to expand their overseas assets, dynamically. The liberalised external payments regime is facilitating the process of acquisition of foreign companies by Indian corporates, both in the manufacturing and services sectors, with the objectives of reaping economies of scale and capturing offshore markets to better face the global competition. Notwithstanding higher outflows, there has been a significant increase in capital inflows (net) to almost five per cent of GDP in 2006-07 from an average of two per cent of GDP during 2000-01 to 2002-03. Capital inflows (net) have remained substantially above the current account deficit and have implications for the conduct of monetary policy and macroeconomic and financial stability.

With the significant strengthening of the current and capital accounts, the foreign exchange reserves have more than doubled from US$ 76 billion at the end of March 2003 to US $ 228.8 billion as on August 31, 2007.

Financial stability

The Indian record on financial stability is noteworthy as the decade of the 1990s has been otherwise turbulent for the financial sector in many EMEs. The approach towards the financial sector in India has been to consistently upgrade it by adapting the international best practices through a consultative process. The Reserve Bank has endeavoured to establish an enabling regulatory framework with prompt and effective supervision, and development of legal, technological and institutional infrastructure. The regulatory norms with respect to capital adequacy, income recognition, asset classification and provisioning have progressively moved towards convergence with the international best practices. The Basel II capital adequacy framework is being implemented in a phased manner with effect from March 2008.

We have observed that the Indian banks’ balance sheets have strengthened considerably, financial markets have deepened and widened and, with the introduction of the real time gross settlements (RTGS) system, the payment system has also become robust. Currently, all scheduled commercial banks are compliant with the minimum capital adequacy ratio (CRAR) of 9 per cent. The overall CRAR for all scheduled commercial banks stood at 12.4 per cent at end-March 2006. The gross non-performing assets of scheduled commercial banks has declined from 8.8 per cent of advances at end March 2003 to 3.3 per cent at end March 2006, while the net non-performing assets have declined from 4.0 per cent to 1.2 per cent during the same period.

Financial markets

Development of financial markets received a strong impetus from financial sector reforms since the early 1990s. The Reserve Bank has been engaged in developing, widening and deepening of money, government securities and foreign exchange markets combined with a robust payments and settlement system. A wide range of regulatory and institutional reforms were introduced in a planned manner over a period to improve the efficiency of these financial markets. These included development of market micro structure, removal of structural bottlenecks, introduction/ diversification of new players/instruments, free pricing of financial assets, relaxation of quantitative restrictions, better regulatory systems, introduction of new technology, improvement in trading infrastructure, clearing and settlement practices and greater transparency. Prudential norms were introduced early in the reform phase, followed by interest rate deregulation. These policies were supplemented by strengthening of institutions, encouraging good market practices, rationalised tax structures and enabling legislative and accounting framework.

A review of monetary policy challenges

The conduct of monetary policy has become more challenging in recent years for a variety of reasons. Many of the challenges the central banks are facing are almost similar which could be summarized as follows:

Challenges with globalisation

First, globalisation has brought in its train considerable fuzziness in reading underlying macroeconomic and financial developments, obscuring signals from financial prices and clouding the monetary authority’s gauge of the performance of the real economy. The growing importance of assets and asset prices in a globally integrated economy complicates the conduct of monetary policy when it is focused on and equipped to address price stability issues.

Second, with the growing integration of financial markets domestically and internationally, there is greater activism in liquidity management with a special focus on the short-end of the market spectrum. There is also a greater sophistication in the conduct of monetary policy and central banks are consistently engaged in refining their technical and managerial skills to deal with the complexities of financial markets. As liquidity management acquires overriding importance, the evolving solvency conditions of financial intermediaries may, on occasions, get obscured in the short run. No doubt, with increasing globalization, there is greater coordination between central banks, fiscal authorities and regulatory bodies governing financial markets.

Third, there is considerable difficulty faced by monetary authorities across the world in detecting and measuring inflation, especially inflation expectations. Recent experience in regard to impact of increases in oil prices, and more recently elevated food prices shows that ignoring the structural or permanent elements of what is traditionally treated as shocks may slow down appropriate monetary policy response especially if the focus is on “core inflation”. Accounting for house rents/prices in inflation measurement has also gained attention in some countries. The central banks are often concerned with the stability/variability of inflation rather than the level of prices. Inflation processes have become highly unclear and central banks are faced with the need to recognise the importance of inflation perceptions and inflation expectations, as distinct from inflation indicators. In this context, credible communication and creative engagement with the market and economic agents have emerged as a critical channel of monetary transmission.

Challenges for emerging market economies

It is essential to recognize that the international financial markets have differing ways of judging macroeconomic developments in industrial and emerging market economies. Hence, the challenges and policy responses do differ.

First, the EMEs are facing the dilemma of grappling with the inherently volatile increasing capital flows relative to domestic absorptive capacity. Consequently, often the impossible trinity of fixed or managed exchange rates, open capital accounts and discretion in monetary policy has to be managed in what could be termed as “fuzzy” manner rather than satisfactorily resolved – a problem that gets exacerbated due to huge uncertainties in global financial markets and possible consequences in the real sector.

Second, in the emerging scenario of large and uncertain capital flows, the choice of the instruments for sterilization and other policy responses have been constrained by a number of factors such as the openness of the economy, the depth of the domestic bond market, the health of the financial sector, the health of the public finances, the country’s inflationary track record and the perception about the credibility and consistency in macroeconomic policies pursued by the country. Further deepening of financial markets may help in absorption of large capital inflows in the medium term, but it may not give immediate succour at the current stage of financial sector development in many EMEs, particularly when speed and magnitude of flows are very high. Some of the EMEs are also subject to adverse current account shocks in view of elevated commodity prices. Going forward, global uncertainties in financial markets are likely to dominate the concerns of all monetary authorities, but, for the EMEs, the consequences of such macro or financial disturbances could be more serious.

Third, the banking sector has been strengthened and non-banking intermediation expanded providing both stability and efficiency to the financial sector in many EMEs. Yet, sometimes, aligning the operations of large financial conglomerates and foreign institutions with local public policy priorities remains a challenge for domestic financial regulators in many EMEs. Further, reaping full benefits of competition in financial sector is somewhat limited in many EMEs. Large players in developed economies compete with each other intensely, while it is possible that a few of them dominate in each of the EME’s financial markets. A few of the financial intermediaries could thus wield dominant position in the financial markets of these countries, increasing the concentration risk.

While it is extremely difficult to envision how the current disturbances in financial markets will resolve, the focus of many EMEs will be on considering various scenarios and being in readiness with appropriate policy strategies and contingency plans. Among the factors that are carefully monitored, currency markets, liquidity conditions, globally dominant financial intermediaries, impact on real sector through credit channel and asset prices are significant, but the list is certainly not exhaustive.

Monetary policy framework in India

Objectives

The basic objectives of monetary policy, namely price stability and ensuring credit flow to support growth, have remained unchanged in India, but the underlying operating framework for monetary policy has undergone a significant transformation during the past two decades. The relative emphasis placed on price stability and economic growth is modulated according to the circumstances prevailing at a particular point in time and is clearly spelt out, from time to time, in the policy statements of the Reserve Bank. Of late, considerations of macroeconomic and financial stability have assumed an added importance in view of increasing openness of the Indian economy.

Framework

In India, the broad money (M3) emerged as the nominal anchor from the mid-1980s based on the premise of a stable relationship between money, output and prices. In the late 1990s, in view of ongoing financial openness and increasing evidence of changes in underlying transmission mechanism with interest rates and exchange rates gaining in importance vis-à-vis quantity variables, it was felt that monetary policy exclusively based on the demand function for money could lack precision. The Reserve Bank, therefore, formally adopted a multiple indicator approach in April 1998 whereby interest rates or rates of return in different financial markets along with data on currency, credit, trade, capital flows, fiscal position, inflation, exchange rate, etc., are juxtaposed with the output data for drawing policy perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform period since the early 1990s. The switchover to a multiple indicator approach provided necessary flexibility to respond to changes in domestic and international economic environment and financial market conditions more effectively. Now, liquidity management in the system is carried out through open market operations (OMO) in the form of outright purchases/sales of government securities and daily reverse repo and repo operations under a Liquidity Adjustment Facility (LAF) and repo and reverse repo rates have emerged as the main instruments for interest rate signalling in the Indian economy.

The armoury of instruments to manage, in the context of large capital flows and sterilisation, has been strengthened with open market operations through Market Stabilisation Scheme (MSS), which was introduced in April 2004. Under the MSS, the Reserve Bank was allowed to issue government securities as part of liquidity sterilisation operations in the wake of large capital inflows and surplus liquidity conditions. While these issuances do not provide budgetary support, interest costs are borne by the fisc; as far as Government securities market is concerned, these securities are also traded in the secondary market, at par with the other government stock.

While the preferred instruments are indirect, and varied, there is no hesitation in taking recourse to direct instruments also, if circumstances so warrant. In fact, complex situations do warrant dynamics of different combination of direct and indirect instruments, in multiple forms, to suit the conditions affecting transmission mechanism. There are occasions when the medium-term goals, say reduction in cash reserve ratios for banks, conflict with short-term compulsions of monetary management requiring actions in both directions. Such operations do warrant attention to appropriate articulation to ensure policy credibility. Drawing a distinction between medium term reform goals and flexibility in short-term management is considered something critical in the current Indian policy environment.

Similarly, while there is considerable merit in maintaining a broad distinction between monetary and prudential policies of the central bank, the Reserve Bank did not hesitate, as a complement to monetary tightening, to enhance the provisioning requirements and risk weights for select categories of banking assets, namely real estate, housing and capital market exposures. These measures were needed to specifically address issues of rapidly escalating asset prices and the possible impact on banks’ balance sheets in a bank dominated financial sector. This combination, and more important, readiness of the Reserve Bank to use all instruments, has a credible impact, without undue restraint on growth impulses.

Some of the important factors that shaped the changes in monetary policy framework and operating procedures in India during the 1990s were the delinking of budget deficit from its automatic monetization by the Reserve Bank, deregulation of interest rates, and development of the financial markets with reduced segmentation through better linkages and development of appropriate trading, payments and settlement systems along with technological infrastructure. With the enactment of the Fiscal Responsibility and Budget Management Act in 2003, the Reserve Bank has withdrawn from participating in the primary issues of Central Government securities with effect from April 2006. The recent legislative amendments enable a flexible use of the CRR for monetary management, without being constrained by a statutory floor or ceiling on the level of the CRR. The amendments also enable the lowering of the Statutory Liquidity Ratio (SLR) to the levels below the pre-amendment statutory minimum of 25 per cent of net demand and time liabilities of banks – which would further improve the scope for flexible liquidity management.

Institutional mechanisms

Monetary policy formulation is carried out by the Reserve Bank in a consultative manner. The Monetary Policy Department holds monthly meetings with select major banks and financial institutions, which provide a consultative platform for issues concerning monetary, credit, regulatory and supervisory policies of the Bank. Decisions on day-to-day market operations, including management of liquidity, are taken by a Financial Markets Committee (FMC), which includes senior officials of the Bank responsible for monetary policy and related operations in money, government securities and foreign exchange markets. The Deputy Governor, Executive Director(s) and heads of four departments in charge of monetary policy and related market operations meet every morning as financial markets open for trading. They also meet more than once during a day, if such a need arises. In addition, a Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets comprising academics and financial market experts, including those from depositories and credit rating agencies, provides support to the consultative process. The Committee meets once a quarter and discusses proposals on instruments and institutional practices relating to financial markets. Besides FMC meetings, Monetary Policy Strategy Meetings take place regularly. The strategy meetings take a relatively medium-term view of the monetary policy and consider key projections and parameters that can affect the stance of the monetary policy. In pursuance of the objective of further strengthening the consultative process in monetary policy, a Technical Advisory Committee (TAC) on Monetary Policy has been set up with Governor as Chairman and Deputy Governor in charge of monetary policy as Vice Chairman, three Deputy Governors, two Members of the Committee of the Central Board and five specialists drawn from the areas of monetary economics, central banking, financial markets and public finance, as Members. The TAC meets ahead of the Annual Policy and the quarterly reviews of annual policy. The TAC reviews macroeconomic and monetary developments and advises on the stance of monetary policy.

Methodology

The importance of monetary policy for industry output is explored by means of

an unrestricted reduced form vector auto regression (VAR) model, in the tradition of

Sims (1980). Because the relationships which are defined in these are highly simplified, VAR techniques do not accurately differentiate between theoretical explanations of observed behaviour; they are in fact, efficient means of extracting ‘stylised facts ‘regarding the monetary transmission process.

We preferred the reduced form non‐cointegrated VAR technique to its two competing formulations: the cointegrated VAR and structural VAR.

As far as cointegrated VARs are concerned, our data is of annual frequency; in such a situation, it was felt that any pre‐testing of a long‐run relationship might not be meaningful.

Therefore, we included the variables in the form in which we expect them to be

stationary. The preference over structural VAR also needs justification. In so far as the

theoretical literature is concerned, there was no unequivocal stance that gave an idea

about the underlying structural relationship between the relevant variables. Therefore,

we preferred the Sims‐type (1992) reduced form VAR. A major critique against such

reduced form VAR is that structural inferences from the impulse responses of such VAR models are sensitive to the ordering of the variables. A solution is often proffered in the form of theoretically meaningful restrictions on the innovations in the VAR process.

While such structural VARs have been quite popular in the literature, a caveat remains

that unless grounded in a solid theoretical premise, there could be a temptation to adopt ‘incredible’ identifying restrictions. The preferred ordering of the VAR is real lending rate, (log) real GDP, an index of wholesale prices (P) and industrial output (captured by real value added or RVA), in that order. This suggests that interest rates do not respond to contemporaneous developments in the other variables in the system, that real GDP responds only to changes in interest rates and that, industrial output responds to developments in each of the other variables because we are concerned only with identifying the monetary policy shocks, this seems sufficient for our purpose. We estimate separate VARs for each industrial sector and compare the effect of a monetary shock on each sector’s output.

With all variables computed in real terms, monetary policy is postulated to be

effective when monetary shocks explain a larger proportion of output variance in that

industry. In view of the low‐frequency nature of the data, we examined the 5‐year ahead accumulated response to the shock.

The monetary shock in the present framework is defined in terms of the real

lending rate. The use of the real lending rate, as opposed to the real money stock or real liquidity in the system, deserves some justification. Since the 1990s, the focus in the developed economies has increasingly shifted towards interest rates as the operating procedure for monetary policy transmission (Borio, 1997). Even in India as well, the erstwhile monetary targeting procedure was replaced with a multiple indicator approach in 1998, wherein the Indian central bank started using the information content in interest rates and rates of return in different markets along with currency, credit, fiscal position, trade, capital flows, inflation rate, exchange rate, etc. and juxtaposing it with output data for drawing policy perspectives. In other words, price‐based indicators of monetary policy gained prominence over quantity‐based indicators employed earlier.

Concluding Remarks

In the current environment, monetary policy in India would continue to be vigilant and pro-active in the context of any accentuation of global uncertainties that pose threats to growth and stability in the domestic economy. The domestic outlook continues to be favourable and would dominate the dynamic setting of monetary policy in the period ahead. It is important to design monetary policy such that it promotes growth by contributing to the maintenance of financial and price stability. Accordingly, while the stance of monetary policy would continue to reinforce the emphasis on price stability and well-anchored inflation expectations and thereby sustain the growth momentum, contextually, financial stability assumes greater importance at the current juncture.

Friends, before concluding, I want to emphasize that several transitions and structural transformation are taking place in the diverse and large society that is India. These encompass social, political, cultural and of course economic factors. Monetary policy is but one element in the complex web of challenges to public policy and there may be occasions when purely technical responses to monetary policy challenges would be less than appropriate. Public policy, including monetary policy, has to reckon with the complexity of managing these multiple transitions. We are fortunate that we have a supportive and stable political system and well-functioning public institutions. We, in the Reserve Bank, are conscious of these complexities and approach issues in a flexible manner with a sense of humility. The primary focus of the paper was to investigate the effects of monetary policy

transmission on the Indian manufacturing sector. Since we did not intend to model

individual industry behaviour in detail, the relevant stylized facts were analysed within a microeconomic setting by means of a VAR model.

The analysis indicates that industries respond quite differently to a monetary

tightening. An examination of the observed response across industries indicates that it

was possible to classify them into two broad groups: those related primarily to changes in consumer expenditure and those principally selling to other industries.

The analytics thereafter explores which industry characteristics can account for

this differential response. The evidence indicates that the differential response seem to

be related mainly to differences in size of the industry and its intensity of working

capital use. As well, the proportion of interest cost is observed to play an important role.

Therefore, both the financial accelerator and interest rate mechanisms assume relevance in explaining why certain industries are more affected by monetary policy vis‐à‐vis others in the Indian context.

The results need to be viewed as preliminary. Further investigation would off

course, be relevant, examining in particular, whether the results are robust to alternative sub‐periods of the sample or even to other monetary policy indicators. However, to the extent that there exists differential influence across industries, there is no gainsaying that monetary policy in the Indian context would need to take on board this hitherto neglected perspective. Addressing such issues constitutes agenda for future research.