The underpinnings of RBI monetary policy: Just mimicking models in US?

Indira Rajaraman has a nice piece on underpinnings of India’s monetary policy. Right at the beginning, she says the article is not the usual noise ones: how much rate cut, too little too late types. But instead analyses the process.

She says earlier worries were MPC members singing similar tunes (even at time of demon). Now the worry is over the divergent vote patterns as members are divided over inflation trajectory:

…. I was somewhat disconcerted by the divergent vote of one of the three RBI (Reserve Bank of India) members of the MPC. The uniform voting pattern across MPC members was initially a matter of concern, and the emergence of dissent in the June policy by an external member was encouraging. But this new evidence of dissension within RBI is worrying. If their differences are centred around the inflation projection model, that is very worrying indeed.

Any inflation model has two basic components. There are the endogenous elements in the model, which power the internal dynamics of price movements. Then there are the exogenous elements that have to be fed in as and when they happen and become known, like acreage sown, rainfall, trade policy (for foodstuffs), international commodity prices and exchange rate movements.

It is these that the committee probably just has not left enough room for. There are multiple sources from which crop intelligence is obtainable on a weekly basis. There is the directorate of economics and statistics in the ministry of agriculture which is supposed to perform this very function. The RBI itself has a vast network of state-level offices, which could have regular liaison with state agriculture departments and directly relay market intelligence reports to the head office.

The problem is that our inflation-projection models follow those in the US or other developed countries, with excessive reliance on formal data, which in those countries are available at the national level in real time. This is India. Without citing Indian exceptionalism, we are more regionally diverse, and less supplied with a formal real-time data base. Informal channels of information flow have to be tapped to get anything like a reliable handle on inflation projections.

I don’t know why RBI does not use its Regional offices as nodes for gathering data and useful information about local dynamics. It is just such a waste of resources. These regional offices could be excellent places for employment of several economists and researchers around as well. Even during MPC constitution, this blog argued that we should have a Regional MPC with wider representation. Having an agricultural economist is an absolute must in such committees.

She says more troubling is to see outreach of credit:

An even more serious problem than inflation projections is about the direction of credit. No matter what happens to repo and lending rates, the credit needs of small-scale and medium-size enterprises (SSMEs) are being systematically neglected. Even at existing lending rates, there is a vast unmet need for formal credit from that sector. The poor credit offtake, which is mentioned in every monetary policy statement, is a result in large part of neglect of small borrowers. Historically, SSME credit needs have been met through the informal channel, where rates are astronomically high.

Even after re-monetization, their pre-demonetization cash channels of credit might still not be fully restored. If there is no replacement of those informal channels with formal bank credit, there will be disaster on the growth and employment fronts. We have priority sector credit mandates in place, but the banking sector views those as a burden to be accomplished with minimal effort at due diligence. The Jan Dhan initiative will remain sadly incomplete if the induction of small savings into formal channels is not accompanied by a corresponding flow of credit to the small borrower.

Luckily, the RBI recognizes this problem, and convened a conference on the subject at the College of Agricultural Banking in Pune at the end of June. Deputy governor S.S. Mundhra (just retired) in his address to the conference (available on the website) captures succinctly the reasons for what he terms “excessive lending to the corporate sector”, where with little effort one could create large credit volumes. “Creating similar volumes in the priority sector would have required commitment of larger resources in terms of branch staff.”

There are quite simply not enough trained banking staff in place with expertise in risk assessment for small loans. There is not enough tapping of expertise available at the Institute of Rural Management, Anand (IRMA) and other such institutions on bringing the credit-worthy small-scale entrepreneur into the formal credit fold. The MUDRA initiative merely re-finances loans. The loans themselves have to originate at the point of the credit need.

The Mundhra lecture identifies a number of organizational infirmities within banks which limit access for the small borrower, including their credit scoring systems. Branch reach is apparently not a limitation, what with data for 2016-17 showing that public sector banks could not achieve the sub-target for micro enterprises (8% within the overall priority sector target), where private sector banks which have fewer branches were able to exceed their target.

Most so called modern macro models do not even look at this aspect. They assume the transmission process will lead to credit reaching out to all. This anyways is a financial inclusion role which requires different sort of intervention.

All in all, the more you read all this the more you feel how we have just copied some ideas without thinking much. The least we could have done is have a wider representation in MPC…


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