Financial Inclusion Empowers Monetary Policy1
Prof. Errol D'Souza, Director, Indian Institute of Management,
Ahmedabad or IIMA; Prof. Umakant Dash, Director, Institute of Rural
Management, Anand or IRMA; Dr. Supriya Sharma, Partner-Insights,
Centre for Innovation Incubation and Entrepreneurship or
CIIE; representatives of the Bill & Melinda Gates Foundation
(BMGF); faculty, students and staff of IIMA; and friends, I commend
all of you on this laudable initiative of Financial Inclusion for Rural
Transformation. It raises the bar by seeking to examine the entire
value chain of financial inclusion and its effect on women
empowerment with the help of research, existing and new data, and
field experiments. I look forward to the findings, especially which
financial inclusion products work, where and why.
I am honoured to be given the opportunity to launch this project.
Drawing from what I do for a living, I thought I will share my thoughts
on how financial inclusion empowers monetary policy and why people
matter for its effective conduct.
Financial inclusion in the sense of access to the formal financial
system for basic financial services at a reasonable cost is now
positioned as a policy objective in more than 60 countries. It is also
central to the United Nation's (UN's) 2030 Sustainable Development
Goals (SDGs) and the G 20's Action Plan on the 2030 Agenda for
Sustainable Development. Several direct developmental effects are
attributed to financial inclusion such as greater mobilisation of
savings, improving conditions for remittances, boosting fiscal
revenues and improving the effectiveness of fiscal transfers. Rather
than a lever or a growth multiplier, however, it is widely viewed as
enhancing the quality of growth by fostering inclusivity and by
enabling other developmental goals such as poverty eradication,
reduction of inequality and women empowerment, to name a few.
Given this overwhelmingly developmental focus on financial
inclusion, the relationship between financial inclusion and monetary
policy is obviously unfashionable. Recently, however, interest is
growing in the effects of financial inclusion on the conduct of monetary
policy and its contribution to human welfare through this channel. The
initial conditions to spur this interest were always in existence. The
UN's Capital Development Fund or UNCDF reports evidence of
financial inclusion contributing to stabler financial systems. Financially
included economic agents appear to be able to ride out interest rate
cycles pro-cyclically instead of being impacted counter-cyclically.
In my remarks today, I would like to contribute to this growing
interest in the symbiosis between financial inclusion and monetary
policy by (a) assimilating the received wisdom and empirical evidence
that has been accumulated so far on the subject; and (b) drawing
applicable lessons therefrom for India. This assumes relevance in the
context of the pandemic during which the loss of life and livelihood
impacted the financially disadvantaged and vulnerable households
and businesses the most. Drawing upon its experience with financial
inclusion, the RBI crafted a pandemic response that reached out in
the form of unconventional measures to those afflicted sections of
society, keeping finance flowing, and financial institutions and
markets functional, especially when personal incomes were lost and
the future was highly uncertain.
In this endeavour, I am emboldened by the significant milestone
that the Reserve Bank of India (RBI) has passed in its journey towards
financially empowering all Indians - I refer to the construction and
public release of a national financial inclusion index (FI-Index) in
September 2021. The index is based on 97 indicators, representing
'access' or the supply of financial inclusion infrastructure, 'usage' or
demand for financial services and 'quality', or inequality in access and
usage due to lack of financial literacy and protection. The index takes
values from 0 to 100 and implicitly sets the goal for the RBI - 100 per
cent financial inclusion for India. By 2021, we have passed the half-
way mark, doing best in access or the supply of the financial
infrastructure, and lagging the most in usage or demand to be
financially included. This assumes importance from the point of view
of the ambitious agenda set up by the National Strategy for Financial
Inclusion (NSFI), 2019-24 and the National Strategy for Financial
Education (NFSE) 2020-25 in its vision of a financially literate and
empowered India.
There are other collateral benefits attached to the FI-Index. For
the first time, efforts towards expanding financial inclusion can be
transparently evaluated against a publicly available and quantifiable
metric. Furthermore, a measurable indicator of financial inclusion can
be incorporated into monetary policy rules and reaction functions to
examine its correlation with output and inflation and their volatility. For
the first time, the influence of financial inclusion on the size and timing
of policy rate changes can be gauged.
Monetary policy maximises human welfare by minimising the
deviations of output from its potential and inflation from the target.
Although it is empirically observed that there is a two-way relationship
between monetary policy and financial inclusion, it is unambiguous
that financial inclusion is able to dampen inflation and output volatility.
This is achieved by smoothing consumption by enabling people to
draw down financial savings in difficult times for everyday needs. In
the process, it makes people interest-sensitive. Moreover, inflation
targeting monetary policy ensures that even those at the fringe of
financial inclusion are secured from adverse income shocks that hit
them when prices rise unconscionably.
At the cost of being slightly technical, therefore, the rest of my
remarks will address four issues that sit at the heart of this confluence:
first, the choice of the appropriate price index as the population gets
progressively included financially; second, the impact of financial
inclusion on output and inflation variability and the trade-off between
them - the dilemma that is central to the conduct of monetary policy;
third, the transmission of monetary policy impulses through the
economy; and fourth, the impact of financial awareness on
expectations and hence on the credibility of monetary policy.
In the final analysis, financial inclusion fosters societal
intolerance to inflation, a social preference for macroeconomic
stability and a sense of the long and variable lags with which monetary
policy operates. This makes it possible for smaller monetary policy
actions to achieve the same goals in a shorter period of time than
otherwise.
II. The Choice of Price Index
Which measure of inflation should monetary policy target to
maximise welfare? Financial inclusion appears to be the lowest in
rural, agriculture-dependent areas where food is the main source of
income. Recent work in the tradition of dualistic models shows that in
the presence of financial frictions - in this case, financially excluded
or credit-constrained consumers existing alongside those that have
full access to formal finance - flexibly determined food prices have a
critical role to play in influencing the real wages and incomes of the
excluded and hence their aggregate demand. Interest rate change
don't matter so much. When food prices rise, the extra income earned
by the financially excluded is not saved but instead consumption is
increased, leading to higher aggregate demand. In this kind of a
situation, the efficacy of monetary policy in achieving its stabilisation
objective increases by targeting a measure of prices that includes
food prices rather than one that excludes them such as core inflation.
The lower the level of financial inclusion, therefore, the stronger is the
case for price stability being defined in terms of headline inflation
rather than any measure of core inflation that strips out food and fuel.
In India, food accounts for 46 per cent of the CPI, among the
highest shares anywhere in the world. Furthermore, the CPI
combines a rural index and an urban index, with the share of food
being even higher in the rural index at 54.2 per cent. In the urban
index too, the share of food at 36.3 per cent is also sizable in a cross-
country perspective. Consequently, aggregate demand is highly
influenced by the behaviour of food prices and farm output, rather
than interest rate changes to which the urban index could be
sensitive. It is in this context that the monetary policy framework
overhaul in 2016 to usher in a flexible inflation targeting regime wisely
chose the headline CPI as its metric for measuring the inflation target
rather than any measure of core inflation, despite persuasive
arguments for the latter that are made even today. Headline CPI
inflation averaged 3.9 per cent since the institution of flexible inflation
targeting right up to the onset of the pandemic in March 2020 (i.e.,
during October 2016 - March 2020). With the first onslaught of
COVID-19, headline inflation breached the upper tolerance band and
averaged 6.2 per cent in 2020-21. Strong supply side interventions to
expand access to buffer stocks and imports, to incentivise
productivity, and lowering of taxes tamed the upsurge and aligned
headline inflation again with the target, barring short-lived spikes due
to inclement weather in key vegetable producing areas. Food inflation
has been volatile throughout this period, reflecting the incidence of
supply shocks on the production of items to which inflation is
particularly reactive. It rose from an average of 2.9 per cent during the
FIT period of 2016-20 to 7.4 per cent in 2020-21 at the height of the
first wave of the pandemic, but the policy interventions have managed
to temper it to 3.5 per cent in April-November 2021. Stabilising farm
incomes and food availability through the pandemic via transfers of
both cash and kind has been a key policy mission. Coincidentally,
financial inclusion appears to have gone up, with the level of the RBI's
financial inclusion index rising from 49.9 in March 2019 to 53.1 in
March 2020 and further to 53.9 in March 2021.
The evidence is still forming and strong conclusions from its
analysis may be premature, but India's monetary policy is by design
financially inclusive and it will reap the benefits of this strategy in the
future in terms of effectiveness and welfare maximisation.
III. Stabilising Output-Inflation Variability
As I mentioned earlier, the responsibility assigned to monetary
policy is to keep output close to or at its potential and inflation aligned
to its target. Financially included consumers are able to smooth
consumption in the face of shocks because of their access to savings
(deposits) and credit from the formal financial system in the event of
income losses. On the other hand, financially excluded consumers
are not able to do so and hence they are vulnerable to higher volatility
in consumption spending and output. An economy with all consumers
financially included would expect to experience less output volatility
due to lower consumption volatility. In an economy with financially
excluded consumers, monetary policy has to assign a greater weight
to stabilising output. Overarchingly, however, it is inflation volatility
that affects all consumers, whether included or excluded. Therefore,
minimising inflation volatility should be the predominant objective of
monetary policy in its welfare maximising role. It follows that the larger
the share of financially excluded people in an economy, the more the
central bank has to pay attention to output stabilisation at the cost of
focusing on inflation stabilisation. As financial inclusion rises,
monetary policy can hone its ability to stabilise inflation and reap
welfare gains for society at large.
In India, the issue of financial inclusion and its role in shaping
the monetary policy reaction function was recognised from the very
outset while instituting the flexible inflation targeting framework.
Accordingly, price stability was assigned primacy among the goals of
monetary policy, with output being a secondary objective to turn to
only after price stability as defined numerically in terms of 4 per cent
with a tolerance band of +/-2 per cent around it has been achieved.
To quote from the RBI Act as amended in 2016: "The primary
objective of monetary policy is to maintain price stability, while
keeping in mind the objective of growth." As I pointed out earlier, this
has been largely achieved, but for the exceptional experience with the
pandemic, and looking ahead, inflation is expected to trend down over
the next two years to converge to the target, as pointed out in the
RBI's October 2021 Monetary Policy Report.
Furthermore, there is some evidence that financial inclusion has
worked in the same direction as the reforms in the monetary policy
framework in the assignment of weights to inflation and output gaps.
The Report on Currency and Finance, 2020-21 estimates that the
coefficient on the deviation of inflation from the target was 0.41 in the
period 2000-11, with 0.75 as the coefficient on the deviation of output
from its potential. During 2016-20, the period of the flexible inflation
targeting framework up to the pandemic's first wave, the weight on
the inflation gap rose to 0.70 while the weight on the output gap fell to
0.26, clearly revealing an increasing focus on stabilising inflation
relative to output. This resulted in stabilising expectations, winning
foreign investor confidence and earning credibility for the conduct of
monetary policy.
Although relatively unsung, rising financial inclusion has had a
significant contribution to this virtuous outcome. It has been argued
that as financial inclusion increases, the ratio of output volatility to
inflation volatility should also rise if the central bank cares about both
and sets monetary policy to optimize their trade-off. In India, this ratio
has gone up from 0.6 in mid-2015 to 1.3 in the last quarter of 2020-
21 just before the pandemic struck. In the pandemic period, this ratio
has shot up to above 5, but this is clearly an outlier which has to be
tackled differently. Looking ahead, as financial inclusion rises even
further in India, consumption volatility as a source of output volatility
can be expected to wane, providing headroom for monetary policy to
remain focused on minimising inflation volatility, which brings welfare
gains for all.
IV. Monetary Policy Transmission
Modern central banks mostly employ the interest rate to convey
the stance of monetary policy to the rest of the economy. Briefly put,
policy rate changes immediately influence short-term money market
rates from which they are transmitted through the continuum of
financial markets to longer-term interest rates, which impact spending
decisions of businesses and households and eventually aggregate
demand. Financial inclusion is found to improve the transmission of
interest rate-based monetary policy impulses in two ways. First, the
financially excluded would typically prefer 'inside the pillow' savings
and for this, cash is the preferred instrument. As inclusion increases,
their preference shifts from cash to interest-bearing bank deposits
and other financial assets. Consequently, the interest sensitivity of
financial savings in the economy goes up. In view of compositional
changes due to interest-bearing deposits replacing currency in
people's portfolios, the interest rate sensitivity of money balances also
goes up. Second, financial inclusion is expected to expand the access
to bank credit, which is interest sensitive and affected by changes in
the policy rate. All in all, financial inclusion enhances the potency of
interest-rate based monetary policy by causing an increasing number
of people to become responsive to interest rate cycles. In turn, this
prompts appropriate smoothing behaviour. There is also some
evidence to suggest that as interest rate sensitivity of the population
increases, central banks need to move interest rates by less to
achieve their objectives.
In India, the growing involvement of people in the monetary
policy process has led to more democratic approaches to interest rate
setting. The RBI moved away from regulating interest rates during the
1990s. This was followed by guideline-based loan pricing norms -
prime lending rates; base rates; marginal cost of funds-based lending
rates. The goal is transparency, customer protection and awareness,
and being as market-based as feasible, all of which are intended to
foster inclusiveness. Across these regimes, transmission of policy
rate changes to both deposit and lending rates has improved. The
process has come full circle with the external benchmark-based
lending rates - applied first to retail loans and credit to micro and small
units - under which transmission is even fuller. Clearly, sustaining
the thrust on financial inclusion will leave the RBI better off in
achieving monetary policy transmission.
V. Expectations and Monetary Policy Credibility
The role of expectations is crucial to the conduct of monetary
policy. People's expectations about the future are typically
conditioned by the past. For instance, inflation expectations tell about
the future course of prices as people see them in the rear-view mirror.
For central banks, such expectations are a crucial input for policy
making because they can crystallise into actual outcomes if the
number of people sharing the same expectations gains critical mass.
Furthermore, central banks can assess whether expectations are
anchored or not, which has a bearing on their credibility. Therefore,
what drives expectations is a question that is valuable for both people
and the central banks that serve them. It is observed that financial
literacy empowers people to choose more relevant information and to
make better use of it. Closer assessment of future inflation helps
inform choices on personal finance decisions, including opening of a
bank account, taking a bank loan or even bargaining for wages.
India has recently stepped up its drive for financial inclusion to
reach unserved and underserved sections of society. The JAM trinity
- Jan Dhan Yojana; Aadhaar; Mobile - is an internationally acclaimed
gamechanger in this regard and is widely regarded as having
completed inclusion on the deposit side. During the pandemic, the
JAM trinity was leveraged to support and save livelihoods. The
NABARD's self-help group bank linkage programme has emerged as
the world's largest microfinance programme in terms of number of
beneficiaries and microcredit extended. The RBI has taken a number
of outreach and public awareness campaigns for financial literacy, the
most visible being RBI Kehta Hai, Interactive Voice Response System
(IVRS), and these initiatives have spanned all types of media. As
these efforts intensify, it is expected that an included and aware
population will participate more in monetary policy formulation and
implementation, develop more rational expectations and induce
financial intermediaries to transmit policy impulses more swiftly and
effectively across the financial system.
VI. Conclusion
Monetary policy authorities typically avoid discussions on inequality.
They like to be seen in a macro-stabilisation role and prefer leaving
distributional issues to fiscal authorities. Yet, increasingly, they realise
that financial inclusion - or the equality of access to formal finance -
impacts the conduct of monetary policy more fundamentally than they
thought, in the choice of metric for measuring goal variables, in the
choice of trade-off between their variances, and in the efficacy of
monetary policy in reaching out to the broader economy. It is in this
context that central banks find themselves integrally involved in policy
drives to expand financial inclusion because they have to take into
account the true financial structures of the economies in which they
conduct monetary policy. As people get financially included, they can
use their access to formal finance to deal with both good and bad
times and in more accurately assessing future inflation. And this has
monetary policy implications, as I pointed out. So, central banks do
care about inequality. After all, social welfare - the mandate of
institutions committed to the greater public good - hinges on it.
Thank you.
References
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