T C A Srinivasa-Raghavan: How firms respond to monetary policy

OKONOMOS/ All firms pare debt when interest rates rise but private ones are less quick to do so

Before the first half of the 18th century, people mostly ran businesses with their own money. But as trade and manufacturing expanded, owned capital proved insufficient to meet the new investment and working capital requirements. So they began to borrow more and more.

In the beginning they only took on debt; but soon someone figured out that if you offered people a piece of the firm via shares, you could raise money more cheaply. It also meant that the risk was shared by all shareholders.

Things went along in this fashion until the third quarter of the 20th century. Then a huge explosion in productivity led to the creation of what, had Milovan Djilas been a Westerner, would have been called the New Class.

This was the class looking for quick profits. Equity finance had finally arrived as major competitor to debt finance.

Meanwhile, the huge worldwide economic growth also resulted in matching increases in paper money and credit creation via the banks. Governments became concerned with the ill-effects of this "" for example, inflation "" and started to practice what has come to be known as monetary policy.

Essentially, this consisted of raising or lowering interest rates. Just how this was done was matter of detail unique to each country.

However, it soon turned out that when you fiddled with the interest rates, there was a clear and direct impact on the borrowing behaviour of firms.

A lot of studies were conducted in the US and Europe to analyse these.

In India, monetary policy began to come into its own only after the economic reforms of 1991. So no studies had been conducted of firm level responses to monetary policy changes.

For one thing, the data wasn't there. For another, no one was interested because there were hardly any shareholders, or for that matter, firms worth the bother.

And, of course, there were the development finance institutions (DFIs) like the Industrial Development Bank of India (IDBI) and ICICI. If the "promoter" of a firm knew a minister or two, his firm really didn't have to worry about mundane things like monetary policy.

A nudge and a wink was all that was needed.

But things have changed now. The DFIs have gone. Good and large firms have multiplied, as have shareholders. India has finally entered the modern financial age.

A Prasad and Saibal Ghosh* decided to do for India what Americans and Europeans have done for their own regions: they decided to find out the "different impact of monetary policy on firms with different ownership and governance features" by examining the behaviour for a sample of Indian manufacturing firms.

They focus "on the differences in the use of bank debt in response to a monetary policy tightening for public versus private firms and listed versus unlisted firms, after controlling for different industry groups and time periods."

It turns out that firm-level behaviour has changed after 1997. "The responses of corporates to a monetary contraction in the post-1997 period has been more pronounced."

The period under study, however, was a peculiarly slow one for business, so maybe more research is needed.

But, basically, the authors found that firms lowered their total debt (in particular bank debt) in response to a monetary tightening.

Second, the private sector response, although in the same direction, is less pronounced than of their public sector firms. This is a mystery.

Third, listed firms borrow more in response to a monetary tightening, driven by an increase in their short-term bank borrowings.

Fourth, during the first half of the 1990s corporates responded less; in the second half they responded more by lowering overall debt, particularly bank debt. But after a while both went up.

Fifth, a split of the sample into large and small firms indicates the existence of relationship lending.

Two policy implications emerge from the analysis. First, the interest rate transmission channel has strengthened since 1998. Second, listed corporates ones exhibit relationship lending (that is, it is helpful if the bank knows more about you than less, which is good for Basle 2, I would think).

*Monetary Policy and Corporate Behavior in India, IMF Working Paper, WP/05/25