Thirdly, there has been growing importance of the assets side of the balance sheet of the banking system in India thereby necessitating a relaxation of the typical assumption made in the "money view" of perfect substitutability of assets of the banking system. For instance, with the progressive reduction in the statutory earmarking of resources from the banking sector for Government, there has been growing importance of allocation of resources for the commercial sector. There has also been increasing accretion to foreign assets in the banking system in the 1990s. Fourthly, the Indian economy, like many other developed and developing economies, has experienced marked cycles in credit markets along with cyclical fluctuations in output.

An empirical investigation of the non-food credit market is undertaken for the post-reform period using monthly data from May 1993 to September 2001 based on the framework of Bernanke-Blinder (op cit). The demand for non-food credit from the banks is largely for working capital finance. Credit demand depends on output, represented here by the index of industrial production (IIP). The dependence on output essentially tends to capture the transactions demand for credit which might arise from working capital or liquidity considerations. Generally, it is expected that a higher output would lead to an increase in the off-take in non-food credit. The other factor which normally determines the demand for non-food credit is the interest rate charged on the bank loans. It is expected that the demand for credit would be negatively related to the lending rate.

Supply of non-food bank credit is postulated to depend on the lendable resources that banks have after meeting cash reserve requirements. It is also expected to be influenced by the secondary pre-emptions by the government through the SLR. Logically, the lower the statutory pre-emptions, the higher would be the resources available for augmenting credit supply. Credit supply is also posited to be responsive to a host of financial prices, specifically the lending rate of banks, an alternate risk-free interest rate of holding government paper, say Treasury Bills6 and equity prices. While government bonds are a substitute for bank lending, equity prices impart balance sheet effects and work in the same direction as the lending rate on credit supply. The equity price is an important variable as the spread between the cost of external and internal finance varies inversely with the borrower's net worth - internal funds and collateralisable resources - relative to the amount required. Furthermore, an adverse shock to a borrower's net worth increases the cost of external finance and decreases the ability of the borrower to implement investment, employment, and production plans.

The empirical investigation is undertaken through a system of simultaneous credit demand and credit supply equations to avoid the 'simultaneity bias' with controls for seasonality. The results7 showed that the demand for non-food credit is predominantly influenced by economic activity embodied in the IIP not only contemporaneously but also by 1-month and 2-month lagged output. Credit demand is found to be inversely related to the bank lending rate with interest elasticity of 0.22, indicating a key role for interest rate policy in supplementing the credit channel in the context of revitalising growth. Output elasticities (both current as well as lagged) of credit demand are higher, in absolute terms, than the interest elasticity of credit demand. This explains the dominant influence of the current slowdown on credit demand and the tendency of the output effects to outweigh the beneficial effect of the declining interest rate conditions

On the supply side, a positive effect of the lending rate of banks on the supply of credit was obtained (a 1 per cent increase in the supply of non-food credit leads to a 0.4 per cent rise in the lending rate). The lending rate of the banks is explained very significantly by its own lagged behaviour, suggesting an inertia in lending rate movements reflecting certain structural rigidities which impart downward flexibility in the interest rate structure in India. Equity prices measured by the BSE National Index have a positive and significant relationship with the supply of non- food credit. This indicates that push factors driving up equity markets and bank lending are similar. In the contrary situation, both the markets are adversely affected, which seems to explain the current slump in equity as well as credit markets.

An analysis of the shock effects over the full-sample time span is conducted by examining difference between estimated and simulated series. In order to assess and quantify the impact of shocks on each endogeneous variable, positive shocks of 1 per cent each on credit demand, interest rate on advances and index of industrial production are given (Table 5.4). Besides, the shock to the cash reserve ratio is analysed through a positive shock (increase) of 1 per cent in bank's lendable resources.

These results show that the direction of the changes are on expected lines. For instance, a positive shock (increase) in interest rate on advances appeared to drive down the credit demand which in turn leads to some fall in industrial production. The fall in output (being a secondary effect) is found to be of a lower order than the fall in the credit demand. A positive shock (increase) to the banks' lendable resources works out to be lower on both the demand for credit (0.80) as well as the IIP (0.34) than their impact from the interest rate shocks. The effect of the shocks is concentrated in the first three years and tapers off thereafter.

With the progressive relaxation of the interest rate regime and the removal of structural rigidities during the post-reform period, the bank lending rate appears to be emerging as an important channel of monetary transmission. The current policy stance of easing of interest rate environment is a necessary though not a sufficient condition to revitalise the growth prospects of the economy. Thus, the credit channel in India supplements and reinforces the interest rate channel rather than supplanting the latter.