Monetary transmission in developing countries: Evidence from India

There are strong a priori reasons to believe that monetary transmission may be weaker and less reliable in low- than in high-income countries. This is as true in India as it is elsewhere. While its floating exchange rate gives the RBI monetary autonomy, the country's limited degree of integration with world financial markets and RBI's interventions in the foreign exchange markets limit the strength of the exchange rate channel of monetary transmission. The country lacks large and liquid secondary markets for debt instruments, as well as a well-functioning stock market. This means that monetary policy effects on aggregate demand would tend to operate primarily through the bank-lending channel. Yet the formal banking sector is small, and does not intermediate for a large share of the economy. Moreover, there is evidence both that the costs of financial intermediation are high and that the banking system may not be very competitive. The presence of all of these factors should tend to weaken the process of monetary transmission in India. This paper examines what the empirical evidence has to say about the strength of monetary transmission in India, using the structural vector autoregression (SVAR) methods that have been applied broadly to investigate this issue in many countries, including high-,middle-, and low-income ones. We estimate a monthly VAR with data from April 2001 to December 2014. Applying a variety of methods to identify exogenous movements in the policy rate in the data, we find consistently that positive shocks to the policy rate result in statistically significant effects (at least at confidence levels typically used in such applications) on the bank-lending rate in the direction predicted by theory. Specifically, a tightening of monetary policy is associated with an increase in bank lending rates, consistent with evidence for the first stage of transmission in the bank-lending channel. While passthrough from the policy rate to bank lending rates is in the right (theoretically-expected) direction, the passthrough is incomplete. When the monetary policy variable is ordered first, effects on the real effective exchange rate are also in the theoretically expected direction on impact, but are extremely weak and not statistically significant, even at the 90 percent confidence level, for any of the four monetary policy variants that we investigate. Finally, we are unable to uncover evidence for any effect of monetary policy shocks on aggregate demand, as recorded either in the industrial production (IIP) gap or the inflation rate. None of these effects is estimated with strong precision, which may reflect either instability in monetary transmission or the limitations of the empirical methodology. Overall, the empirical tests yield a mixed message on the effectiveness of monetary policy in India, but perhaps one that is more favourable than is typical of many countries at similar income levels.