Aug 12, 2017 12:28 PM IST | Source:

Will the RBI’s rate cut have the desired effects?

Policy repo rate cut in October 2016 by 25 bps led to a fall in the base lending rate of banks by only 5 bps and that too after a lag of a quarter but term deposit rates were cut by 50 bps in the same month

By Dr. Rudra Sensarma

Last week, the Reserve Bank of India (RBI) cited decline in inflation, weakening economic activity (particularly in manufacturing) and dampening business sentiments to reduce the policy repo rate by 25 basis points. The macroeconomic grounds for this policy change have been explained by the RBI and discussed at length by several commentators, but from now on what matters is how much the rate reduction will actually impact the economy.

While there are several ways in which policy rate changes transmit through the economy, the bank lending channel is by far the most important one in case of India. However, recent history has shown that banks do not always pass on rate cuts to borrowers thereby rendering a policy driven monetary easing somewhat ineffective.

For instance, the last cut in the policy repo rate in October 2016 by 25 basis points led to a fall in the base lending rate of banks by only 5 basis points and that too after a lag of a quarter (and in the aftermath of the liquidity surge due to demonetisation). However, banks were quick to cut the term deposit rates by 50 basis points in the same month as the policy review. Prior to that, the rate cut in April 2016 led to no change whatsoever in either the base lending rate or the term deposit rates.

I have cited the two most recent instances of rate cuts as examples of the lack of “pass through” of interest rates, but the figure below shows a longer time period over which the repo rate has had to work hard to engender any response in the base rate. The recently introduced marginal cost of funds based lending rate (MCLR) has comparatively been more flexible but then, by the RBI’s own admission, bulk of banks’ lending is still benchmarked to the base rate (because old borrowers are still charged interest rate pegged to the base rate).

The RBI is now going to explore the possibility of linking the MCLR to a market determined rate in what would be yet another attempt to force banks to pass on rate cuts to their customers. Unfortunately, you can take all the horses to the well but cannot force them to drink water. In its attempts to come up with improved loan pricing methods, the RBI has failed to sufficiently highlight the other important factors that constrain banks from passing on the benefit of rate cuts to their customers.

Non-performing assets (NPAs)

Asset quality and, consequently, profitability of banks continued to deteriorate in FY17. According to the RBI’s latest financial stability report, gross NPAs that were 9.2 percent in September 2016 went up to 9.6 percent in March 2017 and could surge to 10.2 percent by March 2018.

It is no surprise that in this environment banks are reluctant to cut interest rates and accept further loss in earnings. The silver lining is that banks have finally started taking some large defaulters to the National Company Law Tribunal (NCLT) to seek resolution under the Insolvency and Bankruptcy Code. The RBI has been nudging banks to do this, having been recently empowered to do so by an amendment in the banking regulation law. As and when banks start witnessing a decline in the share of bad loans on their books, the transmission of monetary policy would drastically improve. Credit growth would then also revive.

Bank capital

Research has shown that monetary policy effects on bank lending is smaller if banks hold lower capital than the regulatory required level. Nearly half of Indian banks (mostly in the public sector) are reported to be in the danger of breaching Basel 3 capital ratio target by the end of 2019.

In such a situation, any liquidity injection into banks by the central bank would typically end up in government securities rather than fresh lending as the former does not require any capital charges. Indeed, bond yields have been far more responsive to policy repo rate changes. The solution is to allow public sector banks to raise capital from the markets with the government bringing down its stakes below the current floor of 51 percent. This will not only allow the banks to develop the capital cushion required to restart lending but also provide them functional autonomy to take business decisions on commercial considerations that would keep bad loans under control.

Interest rate on small savings

The government offers attractive returns on small savings such as Public Provident Fund, Kisan Vikas Patra and National Savings Certificate. This ends up diverting a large part of household savings from banks into these national saving schemes. Since banks have to compete with these schemes they are often unable to reduce interest rates for fear of losing deposits. This prevents them from cutting loan rates.

The government did reform the pricing of its schemes last year by affecting interest rate changes quarterly rather than annually as was the case before. The government could now bring down the spread enjoyed by the investors in these schemes so that there is greater parity with bank deposits.

The RBI may have to cut the policy repo rate in an attempt to boost lending and spending, but the effort could go waste unless immediate steps are taken to ease the structural constraints that impede smooth transmission of monetary signals in the banking system.

(The author is Professor of Economics, Indian Institute of Management Kozhikode)
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