The Reserve Bank of India (RBI), in its second bi-monthly monetary policy, has responded to headwinds in the economy by cutting policy rates by 25 basis points and moving towards an “accommodative stance”.
The monetary policy committee (MPC) believes that there is a need to support efforts to boost aggregate demand and reinvigorate investment activity at a time when inflation is benign.
However, this is just the first step in the direction to lift economic activity. Rate cuts won’t help unless there is transmission going forward. Historically, rate cut transmission has been lower than policy rate cuts, but the recent transmission concerns are justifiable amidst the slowdown in the domestic economy, largely because scheduled commercial banks aren’t playing ball.
Put simply, lower borrowing costs are needed to stimulate higher borrowings, which in turn fuel investment activity. This is one way of helping India’s economy get back on a high growth track.
Transmission is not a one-way ticket and will require banks to respond and transmit the policy actions undertaken by the RBI.
What does the data show?
To help understand the problem, we analysed three key lending rates – namely, weighted average lending rates (WALR) on outstanding loans, fresh loans and median marginal cost of funds based lending rates (MCLR) – since September 2014 to gauge the transmission effect of a policy rate change.
The RBI has slashed policy rates on ten instances during this period while it hiked policy rates on two instances only. However, the analysis has been restricted to eight policy rate cuts and two policy rate hikes as the impact of recent policy rate cuts (April’19 and June’19) will not be captured due to unavailability of data.
Also watch | RBI Policy: What Does a Third Consecutive Rate Cut Mean?
Tabulation of the policy rate change and its consequent change in lending rates (covered above) for various bank groups have been analysed in Table 1.
As the MCLR was introduced in April’16, the details for the same have been examined since then. As a wide range of literature has highlighted that transmission takes place with a lag of 2-4 months, the lending rates studied in the following table have been considered two months following a policy rate change.
Table 1: Impact of the policy rate change on lending rates (bps)
| WALR O/S Loans | WALR Fresh Loans | MCLR | |||||||||||
| Month | Rate change | SCBs | PSB | Pvt | Fore | SCBs | PSB | Pvt | Fore | SCBs | PSB | Pvt | Fore |
| Rate cut scenarios | |||||||||||||
| Jan-15 | -25 | -8 | -7 | -10 | -17 | -38 | -41 | -16 | -19 | ||||
| Mar-15 | -25 | -18 | -14 | -29 | -29 | -22 | -27 | 5 | -41 | ||||
| Jun-15 | -25 | -8 | -10 | -10 | 16 | -9 | -12 | -24 | 17 | ||||
| Sep-15 | -50 | -24 | -24 | -26 | -45 | -28 | -22 | -30 | -61 | ||||
| Apr-16 | -25 | 3 | 3 | 1 | -18 | -4 | 9 | -13 | -54 | 0 | 0 | 5 | -17 |
| Oct-16 | -25 | -8 | -3 | -21 | -1 | -23 | -14 | -48 | -23 | -20 | -15 | -30 | -22 |
| Aug-17 | -25 | -17 | -19 | -15 | 7 | -32 | -25 | -43 | -7 | -20 | -15 | -20 | -15 |
| Feb-19 | -25 | 4 | 2 | 5 | -2 | -21 | -11 | -32 | -33 | -6 | -10 | 8 | -3 |
| Rate hike scenarios | |||||||||||||
| Jun-18 | 25 | 6 | -14 | 41 | 8 | 22 | 34 | 14 | 17 | 18 | 15 | 15 | 29 |
| Aug-18 | 25 | 8 | -12 | 46 | 20 | 14 | 17 | 27 | -9 | 17 | 10 | 15 | 26 |
Source: RBI, CMIE, Authors’ calculation; PSB – Public sector banks, Pvt – Private Banks; Fore – Foreign banks, SCB – Schedule commercial banks
The data shows that transmission takes place with a higher quantum on fresh loans, with much lower quantum changes in the WALR of outstanding loans and MCLR. A complete transmission would warrant a change in the policy rate to also impact lending rates of outstanding loans.
Also, it is the private and foreign banks which transmit rate cuts larger than public sector banks. Private and foreign banks also take advantage of the rate hike with larger transmission.
The reason why everyone is crying foul over transmission is because despite the recent rate cut of 25 bps in February, there has been an increase in WALR – of outstanding loans of all SCBs in the subsequent two months (Mar’19 and April’19).
Possible reasons for lower transmission?
Firstly, the rate cut transmission has been lower on account of a high credit-deposit ratio held by the bank. The banks have to mandatorily have a cash reserve ratio (CRR) of 4% with the RBI and statutory liquidity ratio of 19%. This means that out of the net time and demand liabilities (NDTL) of the bank, 23% is either held with the RBI or invested in government securities. The banks can lend the balance.
It has been observed that since November 2018, banks on an average have a credit deposit ratio of 77-78%, which means that they are lending almost the entire balance amount, creating a liquidity deficit in the banking system. This deficit means the banks are facing liquidity constraints and have to keep their lending rates high.
Secondly, the repo rate cut first gets reflected in the lowering of the deposit rates and is consequently transmitted to lending rates. Although lowering deposit rates is a profitable option for the banks, it makes for lower investment alternative from the investors’ mindset. The investment substitutes for bank deposits are remunerative options for investors which turn investors towards them. With an objective to attract more deposits for effective transmission, lowering of deposit rates becomes onerous.
Thirdly, the marginally weak bank performance continues to remain an impediment for effective transmission. In order to improve the banks’ net interest income, weak bank financials would prefer higher income from advances and lower deposit expense. Hence, in order to improve margins, lowering deposit rates would not consequently mean a cut in lending rates.
Deposit growth conundrum
The central bank’s research on deposits has highlighted that for deposit growth to take place, incomes must grow faster for which there has to be robust economic growth. Income is the most important determinant of deposit mobilisation with there being a weak correlation between interest rates and deposit growth. For economic growth to be faster, the cost of borrowings for investment activity must be lower.
As a precursor, the deposit rates too have to decline. But if deposit rates are lower without consequent changes in lending rates, it will not attract more deposits, making it a conundrum.
The solution to the problem
Economist Indira Rajaraman has recently argued that the premium that government bonds enjoy over the repo rate must fall for the real easing of credit. The term premium is the difference between the ten-year G-Sec yield and repo rate and indicates the amount of premium to be paid for longer duration borrowing.
The following graph juxtaposes the movement in the repo rate with the term premium and is reflective of a high term premium since November 2017.
Chart 1: Repo rate (%) vs Term premium(%)
Source: CMIE
The term premium (higher than 1% in most months) which has been high since Nov’17 has made the passage of rate cuts forward difficult. Term premium has been higher owing to higher G-Sec yields which have been primarily on account of higher government market borrowings to fund the fiscal deficit.
Though a government intervention is imperative to boost the slowdown in the domestic economy, breaching the fiscal deficit target and funding the deficit via higher market borrowings could further widen the term premium and impede monetary transmission.
With investors partially losing confidence in mutual funds, attracting investors towards deposits and adhering to fiscal consolidation are the two key factors to be focused on to aid monetary transmission and in turn propel the economy.
Sushant Hede is Associate Economist at CARE Ratings. Views are personal and are not of the organisation.