There are two major limitations of monetary policy in LDCs like India. Firstly money markets and financial institutions in developing countries like India are highly unorganised, often externally dependent and often fragmented.
The commercial banking system in such countries is restricted almost exclusively to rationing scarce loanable funds to creditworthy medium and large-scale enterprises in the modern sector both in manufacturing and in agriculture.
Small farmers and small-scale entrepreneurs and traders do not get sufficient credit from banks and other financial institutions. They have to depend on private moneylenders who charge very high rates of interest.
There is a second major limitation of monetary policy as applied to the structural and institutional realities of the developing countries. This arises due to the assumption that there is a direct linkage between lower interest rates, higher investment and expanded output as in developing countries.
In such countries there are several ‘structural’ supply constraints preventing the expansion of output even when the demand for it increases. These constraints may relate to inadequate management, lack of essential intermediate products, bureaucratic rigidities, licensing restrictions and, in general a lack of interdependence within the industrial sector.
Such structural supply rigidities imply that any increase in the demand for goods and services will not be matched by increase in supply. Rather, the excess demand for capital (investment) goods will merely raise prices.
In India and other countries, this structural inflation has become a chronic problem made even worse on the cost side by the rise in wages as workers attempt to protect their real’ income levels. The recent report of India’s Fifth Pay Commission clearly illustrates this point.
Moreover, commercial banks hardly provide loan for establishing new enterprises or for financing large-scale projects. So various development banks have been set up for providing ‘venture capital’ for new industries.
In India such banks, especially the IDBI, not only supply long-term finance to industry but also provide various direct entrepreneurial, management and promotional services in the enterprises they finance. Development banks thus have played an important role in the industrialisation process of many developing countries.
However, development banks have come under increasing criticism for their excessive concentration on large-scale loans. Small-scale entrepreneurs often tacking technical, purchasing, marketing, organisational and accounting skills as well as access to bank credit are usually found to borrow money from the exploitative unorganised money market.
In fact, there is still a need for establishing new types of savings institutions and financial intermediaries, not only for mobilising domestic savings from small as well as large savers but also for channelling these financial resources to small entrepreneurs at reasonable (and often concessional) rates of interest.