The Finance Bill, 2016, amended the Reserve Bank of India (RBI) Act, 1934, to define inflation targeting (IT) as the central bank’s primary objective. Passing a law by itself is not sufficient to achieve the objective. Reforms will be needed on two fronts to build institutional capabilities that will add up to a working IT system. These involve (i) changes in the working of the central bank, including, releasing better and more frequent macroeconomic data, analysis and inflation forecasts in a timely manner; constituting the monetary policy committee and putting in place an operating procedure; letting the currency float and liberalizing the capital account; (ii) changes in monetary policy transmission, through financial market reforms.
A central feature of a well-functioning monetary policy is monetary policy transmission (MPT). MPT in India is ineffective. In an ideal world, changes in RBI’s policy repo rate—the rate at which it lends to banks—would affect the entire economy through three channels of transmission. First, banks would change the rates they charge their customers. Second, the bond market would be commensurately affected at all maturities. Third, the exchange rate would change because of the impact of the interest rate change on debt inflows and outflows.
None of these channels works in India. First, India is a bank-dominated economy but the number of banks have not increased noticeably over time. In a decade or so, only two new commercial bank licences were granted in 2015. The landscape is dominated by public sector banks which account for 80% of the deposits but lack competitive energy. Private and foreign banks face a plethora of entry barriers. While RBI has granted licences to payments and small finance banks, these will not move the needle in an otherwise stagnant banking environment.
The relatively smaller number of banks in the economy thwarts competition among the existing banks, who do not feel the necessity to pass on the rate changes to the final consumers. This renders the bank lending channel of transmission ineffective.
Secondly, bond market development has been an important failure of financial sector reforms. In advanced countries such as the US, the bond market is an important transmission channel through which changes in monetary policy affect the yield curve. In India, we do not observe this channel. In the absence of a large and liquid bond market, the burden of MPT falls squarely on the banks. For the bond market to develop, reforms are needed to facilitate the bond-currency-derivatives nexus.
Third, in an open economy with flexible exchange rate and monetary independence, when the central bank changes the policy rate, capital flows in or out of the economy, depending on the direction of the policy rate change. This leads to movements in the economy’s exchange rate. This is the third channel of transmission through which sectors linked to currency movements such as tradables feel the impact of a monetary policy change.
In India, there exist several restrictions on the movement of capital flows. Compared to other emerging economies, India still enjoys a limited degree of integration with international financial markets. So, any change in RBI’s policy rate does not necessarily result in concomitant changes in capital flows. Also, in India, any movement in the currency is actively managed by RBI through market interventions. These reduce the effectiveness of the exchange rate channel of transmission as corroborated by evidence found in our recent paper (Monetary Transmission in Developing Countries: Evidence from India by Prachi Mishra, Peter Montiel and Rajeswari Sengupta). In the absence of an open capital account and flexible exchange rate, the third channel of MPT is rendered ineffective.
In an ideal world, through these MPT channels, the effect of a rate change would be passed on to a large share of the population connected to the formal financial system. In other words, for MPT to be effective, financial inclusion is also important. In India, when RBI changes the policy rate, the impact is felt by a small fraction of the population which has access to the formal financial sector. Only 52% of those aged 15 years and above have accounts at a financial institution in India as of 2014. This is low when compared to 98% in Australia, 78% in China, 96% in Singapore, 98% in the UK and 93% in the US. As a result, a small share of Indian population bears a disproportionate burden of the impact of a monetary policy change.
In the absence of a powerful MPT, the only way a monetary policy change can affect the economy is if it is large in magnitude. For example, when C. Rangarajan was RBI governor from 1992 to 1997, he pursued aggressive monetary contraction in the mid-1990s amidst an inflation crisis. In response, consumer price index inflation went down from 10% to 4% in two years. In those days, because MPT was weak, a large change in monetary policy was needed to combat inflation. Little has changed since then.
Thus, there are three paths that can be followed in the context of MPT: (i) Adopt structural reforms to de-clog the channels of transmission. This entails improving financial inclusion, fostering a competitive environment for banks, improving the functioning of the bond market, liberalizing the capital account and letting the currency float; (ii) Administer big changes in the policy rate; (iii) Do nothing on the first and deliver only small changes in the policy rate. This is least painful and perhaps easiest to implement in the short run, but does not create any real impact on the economy.
The government has done its bit by amending the RBI Act to incorporate IT as an objective. RBI now needs to undertake a series of actions in order to actually become an inflation-targeting central bank.
