Last Updated : Jan 11, 2019 01:46 PM IST | Source:

Opinion | Monetary transmission: Trapped in the middle

Bond issuers benefit while bank borrowers face sharp rise in funding costs.

Moneycontrol Contributor @moneycontrolcom

Renu Kohli

The sudden, sharp decline in inflation since October 2018 has led to divergent interest rate developments. Bond yields have plunged, but loan and deposit rates have climbed. The anomaly has arisen because of quicker transmission of lower inflation to bond market, facilitated by RBI’s bond purchases whereas banks are responding to past monetary tightening in the context of higher credit demand. This uneven monetary transmission is benefiting the government and gilded public-private sector firms, the dominant bond issuers, while bank borrowers face higher nominal and real interest rates.

Headline CPI inflation, which slipped below the 4 percent mid-point target in August 2018, tumbled to 2.33 percent by November — a steep fall from its June peak of 5 percent. The RBI, which tightened 50 basis points in June and August, sharply scaled down its inflation forecasts in December to 2.7-3.2 percent for the second half of this financial year from 4.8 percent in August; currently, inflation is predicted at 3.8-4.2 percent in the first half of 2019 with upside risks. Along with decelerating growth, the sharp reversal in the inflation scenario and outlook has triggered expectations of a change in the course of the interest rate cycle ahead.

But as pointed out earlier, interest rate movements are quite divergent. Falling inflation and open market purchases shifted down the yield curve: the 10-year yield was 65 bps lower by end-December from its September peak (8.09 percent), the 3-month and 1-year Treasury bill rates softened 54 and 79 bps, while corporate bond spreads that had almost doubled with fear and escalated risk after the IL&FS default in September have narrowed considerably over comparable G-secs.

The trend is reverse in the credit market where the interest rates-inflation gap has widened. Loan and deposit rates have risen with the steep fall in inflation. In the five months to December 2018, scheduled commercial banks’ average MCLR and base rates increased 43 and 13bps while the one-year deposit rate is higher by 25 bps. Much of these increases came in the October to December quarter as credit growth outpaced that in deposits by more than 6 percentage points. Banks have met this lift in credit demand more by raising deposit rates and less by unwinding SLR bond investments — the aggregate investment-deposit ratio reduced 0.89 percentage points in the quarter, while the fraction of deposits loaned out rose 2.46 percentage points. This choice isn’t surprising given the pointed drop in yields during this time.

Banks are challenged in mobilizing deposits in current conditions. They compete with higher yielding small savings schemes where rates were revised up last October, besides insurance and mutual funds. The task is stiffer when households’ net financial savings (gross financial savings less financial liabilities) are falling — these were 1.4 percentage points lower in 2016-17 over the previous year and most likely fell some more in 2017-18 because per capita gross national disposable income growth slowed to 8.5 percent from 8.9 percent the year before. Decelerating growth in net financial savings also manifests in slowing deposits growth.

How about borrowers? Faster transmission along the yield curve and non-percolation to banks amidst elevated credit demand has widened the interest rate divide between bonds and bank loans. Bond issuers — the biggest are the government, PSUs and other public entities such as NHAI plus a handful of AAA-rated firms — access cheaper funds with protection in real costs. But bank borrowers — lesser-rated firms and medium-small enterprises — face higher nominal and real interest rates as inflation falls. For this class of borrowers, real interest rates are in the 4 percent region. The higher costs of capital reflect crowding-out by the large borrower government, which accesses the bond market not just directly but also through off-budget financing via other public entities, a feature elaborated and underlined by the recent CAG report.

Looking ahead, the situation could ease as banks get some extra space with resources released by progressive SLR reductions (quarterly 0.25 percentage points from January 2019 to reach 18 percent from 19.5 percent now). Larger liquidity infusion through RBI’s bond buying program (Rs 50,000 crore monthly) may further help restrain an anticipated rise in deposit rates. Constraints upon bank financing — the credit-to-deposit ratio reached 79 percent in December 2018 with credit growth of 15 percent against 9 percent growth in deposits — could ease with these efforts. Interest rates may then align in one direction. But if not, credit demand could choke off at such high real rates of interest.

Renu Kohli is a New Delhi-based macroeconomist. Views are personal.

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First Published on Jan 11, 2019 01:46 pm
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