21
Feb

Monetary Policy Transmission in India – Part 1

By Madhu Srinivas, IFMR Finance Foundation

Monetary policy plays a significant role in determining the trajectory of a country’s economy. While not directly affecting the structure of a financial system, the policy significantly influences the actions of economic agents of the financial system, including financial institutions. In that respect, the mechanics and effectiveness of transmission is of considerable interest to us. In this post, which is the first in a two-part series, we take a brief look at the mechanics of Monetary Policy Transmission in general and how it operates in India.

Introduction

Dr. Raghuram.G. Rajan, former RBI Governor, in a statement after assuming office on September 4, 2013 observed that:

The primary role of the central bank, as the RBI Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.” While there are many views on the objectives of monetary policy, the above statement captures the broad commonalities among the various views and could be taken as the official stance of RBI. This is further strengthened with the RBI formally adopting Inflation Targeting Framework.

It is generally accepted in literature that monetary policy has limited effects on aggregate supply or productive capacity. However, in the presence of credit constraints, the ability of firms to expand capacities is impacted, thus affecting aggregate supply[1]. Following the financial crisis of 2008-09 overall monetary policy transmission seems to have weakened in most Advanced Economies (AE)[2]. In contrast, recent evidence suggests that the interest rate channel, one of the many channels for monetary policy transmission, is strengthening in many Emerging Market Economies (EMEs), including India[3]. This can be attributed, among other things, to reduced fiscal dominance, more flexible exchange rates and development of market segments[4].

Prior to the recommendations of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chair: Dr.Urjit Patel, 2014), India was following reserve targeting as the mechanism for monetary policy transmission – i.e., base money, borrowed reserves, and non-borrowed reserves. However, we have moved towards a formal, interest rate targeting regime (based on CPI) and away from the earlier reserve money system. One of the main reasons for moving from a money aggregate system to an interest rate regime is the erosion in stability and predictability of the relationship between money aggregates, output and prices. This erosion was further exacerbated with the proliferation of financial innovations, advances in technology and progressive global integration.

Mechanics of Transmission

The transmission mechanism can be characterised by the Taylor’s rule of thumb[5] (a simplified version of one of the main quantitative tools used by central bankers to arrive at a nominal policy interest rate) –

i =π + r* + 0.5(π –π*) + 0.5 (y – y*)], or [ i =π* + r* + 1.5(π –π*) + 0.5 (y – y*)]

Where

i = nominal interest rate

π = rate of inflation

π* = inflation target

r*= neutral real rate

(y-y*) = output gap

The policy transmission mechanism broadly involves two steps –

  1. Transmission from the policy rate to key rates in the financial markets
  2. Transmission from the financial markets to final objectives like inflation, employment and output

The effectiveness of transmission in both steps depends to a large extent on the structure of the financial system. The three main components of the system which determine effectiveness are[6] –

  1. The size and reach of the system – given that the formal financial system does not intermediate for most economic agents in India, this weakens transmission
  2. The magnitude of financial frictions – a recent empirical study[7] suggests that the relative scarcity, or impediments, in the provision of public goods in India, such as – enforcement of property rights, efficiency and impartiality of the legal system, adequacy of accounting and disclosure standards –  tend to enhance the frictions in the financial sector and, to that extent, impede policy transmission
  3. The degree of competition in the financial sector – there is evidence[8] that the banking sector is highly concentrated in India, suggesting a low degree of competition in the sector

In sum, it can be said that the structure of the financial sector in India tends to weaken the monetary policy transmission.

Channels of Transmission

Monetary policy transmission in India happens through the following channels –

  1. Interest Rate channel – Empirical studies show that there exists bi-directional causality between call money rates and interest rates in other segments such as the government debt market, credit market or equities market and the forex market[9]. Also studies have shown that the transmission through this channel is asymmetric, i.e the extent of policy rate transmission is different between liquidity surplus and liquidity deficit conditions, with the transmission being more effective during liquidity deficit conditions[10]. One reason could be that banks would be more dependent on liquidity provided by RBI during tight liquidity conditions and hence more sensitive to the short term interest rate influenced by RBI.
  2. Credit channel – India is banking-dominated economy, even though the role of equity and debt markets has been rising the past few years[11]. High-dependence on bank finance makes the bank lending and the balance sheet channels particularly important for monetary transmission, which is also seen through Granger causality tests[12]. In terms of balance sheet effects, credit growth is seen to have an inverse relationship with movements in the policy rate. A 100 basis points increase in policy rate reduced the annualised growth in nominal and real bank credit by 2.78 per cent and 2.17 per cent, respectively[13].
  3. Exchange Rate channel – The exchange rate channel works primarily through consumption switching between domestic and foreign goods. This channel is weak in India with some evidence of weak exogeneity[14]. This is mainly because of India’s limited integration with world financial markets and RBI’s intervention in forex markets[15]. Despite all this, it is found that exchange rate depreciation is a key source of risk to inflation[16].
  4. Asset Price channel – Empirical evidence for India indicates that asset prices, especially stock prices, react to interest rate changes, but the magnitude of the impact is small[17]. With the increasing use of formal finance for acquisition of real estate, the asset price channel of transmission has improved. However, during periods of high inflation, there is a tendency for households to shift away from financial savings to other forms of savings such as gold and real estate that tend to provide a better hedge against inflation. To the extent that these acquisitions are funded from informal sources, they may respond less to contractionary monetary policy, thus weakening the asset price channel in India[18].

In all this, it should be borne in mind that there is considerable lag in the transmission of monetary policy. In India, monetary policy impacts output with a lag of 2-3 quarters and WPI inflation with lag of 3-4 quarters, with the impact persisting for 8-12 quarters. Also as can be seen from the above summary of channels, the interest rate channel is the strongest[19].

In the next post, we will take a closer look at the impediments to policy transmission in India and also list the recent measures taken by RBI/Government to overcome these impediments. Finally we will look at what recent empirical evidence has to say on effectiveness of policy transmission in India.


[1] Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chair: Dr. Urijit Patel, 2014)

[2] Bouis (2013) et al, OECD Working Paper No. 1081

[3] Mohanty, M.S. and P. Turner (2008): “Monetary Policy Transmission in Emerging Market Economies: What is New?”, BIS Policy Paper No.3, January

[4] Gumata, N., A Kabundi and E. Ndou (2013): “Important channels of transmission of monetary policy shock in South Africa”, ERSA Working Paper No. 375, Cape Town

[5] Urjit Patel Committee Report (2014)

[6] Mishra, Montiel and Sengupta (2016) :“Monetary Transmission in Developing Countries – Evidence from India”

[7] Ibid

[8] Ibid

[9] Urjit Patel Committee Report (2014)

[10] Bhupal Singh (RBI 2011) :“ How asymmetric is the monetary policy transmission to Financial markets in India”

[11] Ibid , Chart IV.1

[12] ibid

[13] Pandit, B.L. and P. Vashisht (2011), “Monetary Policy and Credit Demand in India and Some EMEs”, Indian Council for Research on International Economic Relations, Working Paper No.256, Khundrakpam (2011) and Khundrakpam and Jain (2012)

[14] Ray, P., H. Joshi and M. Saggar (1998): “New Monetary Transmission Channels: Role of Interest Rate and Exchange Rate in the Conduct of Monetary Policy”, Economic and Political Weekly, 33(44), 2787-94

[15] Mishra, Montiel and Sengupta (2016): “Monetary Transmission in Developing Countries – Evidence from India”

[16] Urjit Patel Committee Report (2014), Table IV.1

[17] Singh, B. and S. Pattanaik (2012): “Monetary Policy and Asset Price Interactions in India: Should Financial Stability Concerns from Asset Prices be Addressed Through Monetary Policy?”, Journal of Economic Integration, Vol. 27,167-194

[18] Urjit Patel Committee Report (2014)

[19] ibid

6
Feb

The Innovative Finance Revolution

Foreign Affairs magazine in association with The Rockefeller Foundation has published a special issue titled “The Innovative Finance Revolution”. The issue focuses on how innovative finance, characterised by financial tools such as pooled insurance and securitised debt among others, can put the power of private capital markets to work for the public good and can unlock new resources and lead to cost-effective interventions.

Img_FAThe report features essays that lay out the context of innovative finance, and focuses on innovative finance solutions, technological innovation and policy frameworks. As part of this publication, Sucharita Mukherjee, Deepti George & Nikhil John have authored a chapter titled “Investing in the Transformation of Financial Access in India”. In the chapter the authors lay out the financial access scenario in India and provide a perspective on the innumerable challenges that a well-functioning financial system can effectively mitigate for India’s individuals, households, enterprises and local governments and IFMR Holdings role in addressing it. Through the chapter they highlight the underlying core philosophy that drives all our efforts and the work of each of our entities towards our mission of ensuring that every individual and every enterprise has complete access to financial services.

You can read the full publication here and the particular chapter here.

31
Jan

All’s well that repays well? Not necessarily.

By Vaishnavi Prathap, IFMR Finance Foundation

The past year has seen many commentaries on the rapid expansion of microfinance in India warning of the imminent consequences of unbalanced growth. The most striking statistic in this context — that the average client’s dues more than doubled in just four years (between 2012 and 2016), far outpacing only moderate growth in numbers of branches, employees or clients, and surely clients’ incomes — was estimated from data that, at best, captures only a large proportion of the microfinance market. While this has triggered ruminations of an emergent repayment crisis, these fears have been tempered on two grounds. First, the enforcement of new regulations since 2012 limit the risk of client over-indebtedness. Second, delinquencies have consistently remained low over the expansionary period, and wherever reports of distress have surfaced, they seem mostly uncorrelated with the sector’s growth rate.

But do these arguments show us the full picture? Considered against primary evidence from the financial diaries of low-income households in India, we find that often they do not. The data, collected by IFMR Finance Foundation during a study supported by the CGAP Customers at the Center Financial Inclusion Research Fund, provides rich detail on the financial lives of borrowers in a competitive and mature microfinance market. It reveals that the indicators cited by both arguments above are poorly correlated with the incidence of over-indebtedness and with the ways in which borrowers experience and cope with repayment distress.

Timely repayments and borrower distress are not mutually exclusive

Aggregated data from lenders’ administrative records, such as delinquency estimates published by credit bureaus, have traditionally served to indicate portfolio quality. When delinquencies are low, it is interpreted as a signal of positive borrower outcomes. However, the repayment record may not fairly represent borrowers’ experiences if lending practices emphasize timely collection above all else.

The financial diaries of over-indebted borrowers illustrate this fact. Of the 400 households we studied, nearly one of every five borrowers reported repayment obligations higher than they could reasonably afford, given their incomes and minimum living expenses. Yet, as many as 85 percent of those over-indebted borrowers never missed a repayment on formal loans, arguably since they had strong incentives (both institutional and social) to do so.

Further, the records submitted to bureaus seldom distinguish between repayments made by the client and payments made by group members on her behalf. Thus, perhaps as an unintended consequence of the design of joint liability, the administrative data reveal few meaningful insights at a sector-level on borrowers’ distress or well-being.

Not consumption smoothing but repayment smoothing

How is it possible for so many borrowers to consistently avoid delinquency while carrying multiple, unaffordable loans? The data suggest they are using several coping mechanisms, such as lowering consumption or postponing essential expenses; raising resources from friends and social networks; and using large formal loans when available to settle old debts, including smaller informal ones accrued in past months. This use of coping mechanisms in the face of shocks is not unlike previously documented evidence. Low-income households use a variety of strategies to insulate their consumption and standard of living from the risk of volatile incomes; alternatively, they try to minimize the impact of income volatility by diversifying their occupations and resources. These strategies have a limited ability to protect households from poverty, and it has been shown that severe or persistent shocks are a major cause for chronic poverty.

The use of coping mechanisms by over-indebted borrowers differed from these practices in one regard — the incidence of coping behavior was highly correlated with the unaffordability of household debt and appeared to revolve around insulating repayments rather than consumption. Borrowers with more unaffordable debt used negative coping mechanisms more often and to a greater degree than others. Their financial behavior was not unlike the expected response to an income or health shock. But in this case, the shock came in the form of multiple non-negotiable loan repayments. Unlike a random occurrence, these “repayment shocks” persisted month after month.

Additionally, not only was the level of debt correlated with distress, but also with certain product features embedded in the loan contract. For example, a subset of borrowers experiencing highly volatile cash flows might have more trouble meeting repayments at certain times of the year. We found that these borrowers, for whom repayments were occasionally unaffordable (when calculated against a given month’s income instead of the average), experienced higher levels of distress, almost on par with those for whom the repayments were almost always unaffordable.

The implication for microlending is that poorly matched repayment schedules and other product features could be just as harmful as too much debt — and more harmful if combined with high levels of debt. This is a critical dimension of the experience of over-indebtedness, yet it is often overlooked.

New lending rules to prevent unsuitable loans

It is evident from the observed level of financial distress that current practices to prevent over-indebtedness are not effective. In fact, critical fault lines in their implementation have created an environment where unsuitable credit remains the primary coping mechanism even for over-indebted borrowers. It is also concerning that they focus heavily on limiting the amount of client debt while ignoring other aspects of borrowers’ cash flows that are significant in mediating financial distress. These include large seasonal or cyclical effects for specific lines of income or, even more generally, total income volatility (the median household in our sample experienced monthly income swings as high as plus or minus 45 percent) as well as large and significant uninsured (but insurable) risks.

Beyond better repayment assessments

Microfinance in India is no longer dominated by monopolistic or mono-product markets. With the licensing of several large lenders as small finance banks, the expectation is now that low-income households will have access to better financial services. This means not only easier access to a wider set of services, but services provided by institutions that are better equipped to respond to low-income households’ primary needs and vulnerabilities.

Many have argued that the continued success of lending to low-income households will require the evolution of robust mechanisms to assess clients’ capacity to deploy credit and manage repayments. By itself, this will not be enough to prevent borrower distress since repayments alone do not signal that a loan is suitable.

Lenders must also adequately detect clients’ cash-flow vulnerabilities and respond to them with appropriate design and service improvements, complementary savings and insurance products, flexible repayment schedules where appropriate, and best practices for delinquency management.

Read the latest version of the paper here. This article first appeared on the CGAP blog.

19
Jan

Guidelines for Suitability in Lending to Low-Income Households

By Vaishnavi Prathap, IFMR Finance Foundation

Img_1In December 2014, the Reserve Bank of India published the Charter of Customer Rights as a commitment to protecting the interests of consumers of financial services. The charter includes the Right to Suitability, defined as the principle that “products offered should be appropriate to the needs of the customer and based on an assessment of the customer’s financial circumstances and understanding”. The MFIN and Sa-Dhan, in a joint Code of Conduct, also enshrine a similar principle but specific to the context of lending: “We, as part of the Microfinance Industry promise the customers that we will […] conduct proper due diligence to assess the need and repayment capacity of customer before making a loan and must only make loans commensurate with the client’s ability to repay”. Both the RBI and the SROs directed financial institutions to understand the parameters of suitability within the context of their respective product offerings and to formalize policies to prevent unsuitable sales to customers.

In a new research paper published as part of our Working Paper series, we focus on biggest barrier that financial institutions might face in complying with this directive – a lack of clarity on what may be deemed suitable and how this is to be determined for each client. Towards this end, our new research investigates the nature and incidence of unsuitability in a competitive lending market and the variety of ways in which low-income borrowers may experience or cope with loan-related financial distress. Our findings are both a reality-check on the effectiveness of the current approach to customer protection (particularly the efforts to prevent borrower over-indebtedness) as well as a guide to how, going forward, lenders can institute formal processes to prevent unsuitability.

In our previous writing on this topic, we have acknowledged that successful suitability practices must be iterative and that even at-best, they can in no way guarantee positive outcomes for clients. The focus of both compliance and supervisory efforts must rest instead on understanding patterns in product-client interactions – especially when such interactions result in substantial hardship to clients – and meaningfully improving sales processes to prevent unsuitable sales.

Key Findings

The primary data for this study was collected in a year-long panel survey of 400 low-income households in Krishnagiri district, Tamil Nadu; the full sample included clients of 7+ MFIs and 20+ formal financial institutions. The survey adopted a financial diaries approach and a detailed socioeconomic survey was administered every 4-6 weeks to capture the dynamics of households’ cashflows. The resulting dataset has a primary focus on the details of borrowing and loan servicing but also rich detail on the volatility of occupational income, the frequent incidence of small and large shocks to household budgets and the use of other income sources, resources from social networks and a variety of financial instruments to smoothen consumption, repayment obligations and other expenses.

From the survey, we were able to create a full picture of borrower indebtedness across multiple institution types – perhaps more completely than the credit bureaus for microfinance clients. Comparing the sum of monthly repayment obligations to borrowers’ average monthly incomes, we found that one of every five borrower households in the sample held an unaffordable level of formal debt. If we included informal loans or factored in the volatility of incomes, an even higher proportion held unaffordable levels of debt for a few or all months of the loan tenure. However, the incidence of repayment delays or the proportion of delinquent borrowers was much lower, and only weakly correlated with households’ debt levels. Even at very high levels of unaffordability, borrowers were prioritizing repayments on formal loans over essential expenses, and willing to take on even further unmanageable debt to get through a difficult period.

Further, the average households’ incomes varied month-on-month by as much as 45% and as a result, even borrowers with sufficient year-end surplus were observed experiencing periods of distress and using harmful coping mechanisms comparable to those whose incomes were much lower.

Implications for Suitability Practices

These patterns in borrower behaviour are perhaps not new to experienced practitioners of microfinance and further, may only be a reflection of practices designed to achieve repayment discipline. What is alarming however, is the relative ease with which some over-extended borrowers remained undetected, and were able to continuously receive new formal loans on the same terms as others.

NBFC-MFIs are subject to regulatory directives that restrict the level of indebtedness per client and additionally, a large part of the non-NBFC microfinance lending is also required to be reported to credit bureaus so that it may be available at the time of loan appraisal. Notwithstanding, we find that critical faultlines in the preparation and use of credit reports placed as many as 33% MFI clients in the sample at risk of being mis-sold an unaffordable loan.

More critically, the types of client assessments that inform loan-making are largely unregulated and often do not triangulate borrowers’ actual repayment capacity (relying instead on unverified or indicative measures, peer selection and group enforcement). Our results show that in a mature and competitive market, clients with similar incomes and livelihoods may in fact have very different borrowing portfolios and vice versa. In this scenario, universal lending limits— such as those currently in effect— poorly safeguard customers’ interests.

Instead, determined efforts should be directed towards building market capacity to conduct thorough client assessments and to respond meaningfully to clients’ financial situation. Credit reports urgently need to be strengthened to reflect a comprehensive view of all formal borrowing, without exception. On the lenders’ side, the use of comprehensive “combo” credit reports will still fall short if not also complemented by a robust understanding of what portion of household income can be made available for repayments. Further, clients with unique liquidity constraints or cashflow risks must receive adequate insurance either through appropriate products or through modified terms of service.

This research highlights not only how critical these measures are for borrower well-being, but also the challenges involved in suitably serving low-income households’ financial needs. As a step in this direction, this research outlines two minimum components for suitability assessments –

  1. All lenders should ensure that loan amounts are appropriate and the agreed repayment terms are affordable for every borrower given their income flows, outstanding loan repayments (including self-reported informal loans) and critical payment obligations.
  2. Lenders must also evaluate the harms of selling standardized products to those borrowers with highly volatile cashflows or those with unique liquidity or flexibility constraints. Uninsured cashflow risks must be provisioned for in the assessment, product design or terms of repayment.

The paper also outlines recommendations for coordinated regulatory, practitioner and research effort that can enable successful implementation. 

The working paper is available online here and we welcome both questions and comments.

18
Jan

NBFCs’ Collection Efficiency Takes a Hit Post Demonetisation

By Bindu Ananth & Kshama Fernandes

Non-banking finance companies (NBFCs) represent an important linkage between the formal banking sector and informal segments of the real economy in India (wage labourers, smallholder farmers, unorganised retail, and domestic workers) through the channelling of credit from the former to the latter.

They have a significant presence in the microfinance, small business finance and commercial vehicles finance segments. Of the 11,682 NBFCs registered with the Reserve Bank of India as of end-March 2016, 209 were systemically important non-deposit taking NBFCs which are subject to more stringent prudential norms and provisioning requirements. Loans & advances by these entities alone accounted for around Rs 10.7 lakh crore. Through the data lens of collection efficiencies and disbursement volumes of over 100 NBFCs, we take stock of the impact of demonetisation on them. This also provides insights on the ultimate impact on the informal economy in India.

From November 9 onwards, NBFCs were not permitted to accept repayments in Rs 500 and Rs 1,000 denomination notes. Given the lack of access to bank accounts, most NBFCs accept repayments in cash from their customers. The average collection efficiency of microfinance NBFCs was 99.02% for the 12 month period preceding Nov 16. As of end November, collection efficiencies dropped significantly for these NBFCs and ranged from 60% to 90%.

Vehicle finance NBFCs reported a collection efficiency ranging from 60% to 70% with a higher cheque bounce rate and reduced overdue collections. Vehicles engaged in the movement of goods/ passengers which are “discretionary” witnessed an increase in idle time of 15-20 days a month from the normal levels of 8-10 days. Nondiscretionary goods, including agri produce and dairy, witnessed a lower impact.

Small business lending NBFCs reported a collection efficiency ranging from 65% to 85% with entities lending to small manufacturers and traders being at the low end of the range. Informal salaried customers have been as affected as self-employed customers with collection efficiencies of around 70%. This is true across urban and rural locations. In the affordable housing finance segment, collections continue to hold strong. These are largely selfoccupied homes. LTVs in this segment are much lower and reflect significant borrower equity in the asset. The norm for fixed obligation to income ratios in the informal segment is significantly lower and may provide a reasonable cushion to absorb short-term cashflow shocks.

Many microfinance NBFCs had put disbursements on hold for all of November 2016 and are now restarting disbursements gradually. Some restarted disbursements partly from their own collections. In the vehicle finance segment, disbursements are at 50-60% of normal levels on account of the slowdown in demand. Fresh disbursements in the small business lending segment have almost stopped with fresh logins dropping to 25% of the normal monthly volumes. Overall, disbursements have been affected also due to shortage of currency in the banking channel and a weekly cap on cash withdrawal. Going forward, we also expect an impact on disbursements in used vehicle finance due to the anticipated crunch on margins for fresh borrowing by the end-customers.

In pockets of UP and Maharashtra, demonetisation has fuelled some political risk factors in the form of demand for loan waivers by local politicians. This needs to be tracked closely and prevented from escalating by local offices of the RBI and the district administration. Going forward, NBFCs will need to re-engineer operations to significantly move away from cash collections. The task of opening bank accounts with full functionality for rural customers is far from complete. The availability of payment mechanisms such as the Unified Payment Interface (UPI) on feature phones will greatly help this category of customers from the advances in this area. There is also a need for a sharp increase in cashin/cash-out points, particularly in remote rural India to facilitate ease of transactions as the progression to cashless/ less-cash economies will take time.

The disruption will have a marginal impact on profitability of NBFCs due to foregone disbursement. We want to share our concerns on the negative liquidity and income impact on customers of these NBFCs which may not show up in collection data of lenders. Salaried workers in the informal sector have been hurt through delayed payment of wages and self-employed workers have seen significantly lower business volumes. Disruptions in credit impact consumption for low-income households in terms of reduced expenditure on essential items such as food and health. There could be a possible loss of trust in formal financial institutions. We need to work hard to restore an environment that will ensure predictability and credibility of these institutions among this large segment of India’s working poor.

This article first appeared in Economic Times.