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Rate cut transmission: Why RBI action is ineffective

RBI has told banks to link their interest rates to external benchmarks instead of MCLR.

, ET Bureau|
Updated: May 15, 2019, 04.35 PM IST
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DK Mittal, financial services secretary during the tenure of the UPA-II administration, preached from the pulpit. Bank chairmen often received letters from the 1977 batch IAS officer, who would set seemingly unattainble targets and deadlines to actualise North Block’s policy decisions. But the sermon that did shine the arclights on Mittal was his letter to high-street lenders after the April 2012 monetary policy. Even before the ink dried on the Reserve Bank of India’s decision to cut interest rates, Mittal directed bank chairmen to conduct an immediate review.

That, critics of an independent financial ecosystem said, amounted to exceeding his brief and setting poor corporate governance precedents.

“With the reduction of CRR and repo rate, all lending rates be relooked at very quickly,” Mittal had then written, assuming no bank would do that unless the owners of government lenders sent a message from New Delhi.

Transmission of monetary policy, or the lack of it, and effectiveness of repo rate as a monetary policy tool have been called into question ever since.

After half-a-decade of that eventful saga, Mint Street saw its incumbent Governor Shaktikanta Das urge top bankers to lower lending rates and help boost a sagging economy. He had cut the repo rate in the February 2019 policy but banks seemed to ignore the signal, holding their respective marginal cost-based lending rate (MCLR) steady before Das sought to persuade the lenders.

Transmission remained partial as the incremental build-up in their deposits continues to lag credit growth. And lending rate cuts follow softer deposit rates, albeit after a lag of not less than six months. Then, interest rates on small savings remained at elevated levels compared to that of banks, making it virtually impossible for them to lower deposit rates.

Lending snip 1

“Transmission is difficult because public sector banks do not borrow from RBI but depend on public deposit for their business,” says United Bank of India chief executive Ashok Kumar Pradhan. “Again, impounding of bank money by RBI is too high with 4% cash reserve ratio carrying no return whatsoever. To make transmission work, the least the RBI can do is to tweak CRR,” he says.

CASH RESERVES AND RATES
Former State Bank of India chairman Pratip Chaudhury was the first crusader against CRR and had lobbied for abolishing it and had a fierce verbal duel with deputy governor KC Chakrabarty on that issue.

“The issue with interest rates in India is that a majority of the deposits are at a fixed rate, which means banks cannot change them at short notice. SBI has taken the lead to change things by linking some of its deposit rates to a market benchmark but its whole impact is yet to be ascertained. RBI has no choice but to leave it to banks to transmit rates and push them to do so when they are slow,” said Saurabh Tripathi, senior partner at BCG.

Deterioration in banks’ asset quality and the losses incurred by public sector banks have hampered effective monetary transmission through bank lending rates and credit supply. RBI’s sixth bi-monthly monetary policy statement of 2016-17 (February 2017) had observed that the environment for timely transmission of policy rates to banks’ lending rates would be considerably improved if the banking sector’s non-performing assets (NPAs) are resolved more quickly and efficiently. But it took longer than anticipated.

LIQUIDITY AND MONETARY POLICY
RBI had to use exceptional liquidity management measures to align the operating target with the monetary policy stance since 2008, following the post-global financial crisis liquidity scare, post-taper tantrum liquidity shock, and postdemonetisation liquidity glut.

“The implementation of monetary policy has to often contend with episodic liquidity shocks and the associated risk of significant and sustained deviation of the operating target from the policy rate, notwithstanding proactive deployment of a variety of liquidity management tools by RBI to anchor the operating target close to the policy rate,” Rajesh Kavediya and Sitikantha Pattanaik, advisors in different RBI departments, said in a paper published in May 2018.

CREATING A BENCHMARK
RBI has told banks to link their interest rates to external benchmarks instead of MCLR to ensure better transmission of monetary policy rates. The options to banks are linking rates to repo rate, the 91-day T-bill yield, the 182-day T-bill yield, or any other benchmark market interest rate produced by the Financial Benchmarks India.

“There is no perfect system across the world but ultimately as markets develop and deepen, there is more transparency in benchmark rates which can be used for transmission. However, even in the developed market, we have seen what happened with the LIBOR scandal, so there is no perfect system. In India, we will have to continue to experiment and find a benchmark. It is currently work in progress but needs more time. As our markets develop, we will move toward benchmarks that are transparent,” BCG’s Tripathi said.

SBI has linked interest on large savings bank deposits with repo rate from May 1. The banking behemoth has also linked its cash credit and overdraft rates to repo rate to ensure immediate relief to overdraft and cash credit borrowers in a falling rate regime. However, this cannot be extended to term loans and other facilities. This is a complex issue and it is unlikely that the current system will ever see 100% transmission because people here depend on bank deposits for social security. About 95% of banking liabilities here are in deposits, unlike the developed markets where banks largely depend on market borrowings.

THE LONG AND SHORT OF IT
“Many will argue that given the current state of India’s banks, interest rate cuts are unlikely to be transmitted to any significant decline in lending rates. So maybe thinking about growth as a separate objective meets the letter of the MPC’s flexible objective but not its spirit,” said Jahangir Aziz of JPMorgan.

“If the government truly wants to reduce lending rates in India in a meaningful and sustained manner, it would be far better served to focus on bringing down its own fiscal deficit, including the large recent increases in off-balance sheet and public sector borrowing. Today, overall public sector borrowing, without including state-run electricity distribution companies, is somewhere between 9% and 10% of GDP, the highest in many years. If this is brought down such that yields at the long end are anchored, the entire structure of lending rate in India will come down substantially and without the RBI having to cut rates at the short end,” he said.
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