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Last Updated : Jun 07, 2019 03:32 PM IST | Source:

Explainer | RBI policy transmission: Why such a big buzz?

It’s a given that lower borrowing costs help stimulate economy. The government as well as the RBI are pretty much on the job. However, the plain truth is the trickle-down effect is easier said than done.

Moneycontrol Research @moneycontrolcom

What is the meaning of 'transmission' in the context of monetary policy?

The word transmission means passing on something from one place to another. In the context of monetary policy, it simply means that the action by the central bank is replicated by the banking system in equal magnitude. For instance, if the RBI lowers policy rate by 25 basis points (one percent equals 100 basis points), it expects banks to reduce their lending and deposit rate by a similar percentage for its action to have the desired effect on the economy.

Why is monetary transmission important?


A poor transmission means the apex bank lowering/increasing rates and banks not following suit. Such a move renders RBI’s policy ineffective. Central banks typically tinker with interest rates to manage growth and inflation.

To take an economy out of a slowdown, the Reserve Bank would reduce rates so that borrowing becomes cheaper, individual and firms borrow more and spend more so that demand improves leading to economic revival.

Similarly, when inflation is high, that can eventually impact economic growth, in which case the central bank resorts to interest rate hike. As money gets dearer, borrowing gets reduced, demand declines, leading to fall in prices.

Why was transmission weak in India in the past?

In the past, banks had been saddled with non-performing assets (assets that are unable to service principal and interest repayment).

Bank’s interest margin, a core indicator of profitability, is the difference between earnings on interest-bearing assets and investments and cost of resources, principally deposits. When banks have high NPAs, their interest margin comes under pressure as they are not earning from the entire asset book whereas they are paying interest on the entire liability. This limits their ability to reduce lending rates even when policy rates go down although they pay less on liabilities i.e. lower deposit rates.

Why is the transmission so weak now?

In the current scenario, one of the most important reasons for weak transmission is because of slow growth in deposits. Credit growth in the last fiscal at 13 percent is well ahead of deposits growth of 10 percent.

The slow disbursement growth of NBFCs after the IL&FS crisis, which has resulted in mutual funds halting their lending to most NBFCs, has put greater responsibility on banks to address the credit demand of the system.

However, banks need resources (i.e. deposits) to cater to this credit demand. Banks are increasingly finding it difficult to garner deposits as there has been a gradual decline in gross domestic savings, led chiefly by lower household savings.

Another reason for lower bank deposit growth is the rather high interest rates offered by alternative instruments like small savings schemes. Hence, even if policy rates go down, banks are finding it difficult to lower deposit rates. Unless deposit rates fall, lending rates cannot decline, thereby leading to poor transmission of RBI’s policy action.

What has RBI done to improve transmission?

Since the deregulation of interest rates in the early 1990s, the RBI has made several attempts to improve the speed and extent of the monetary pass-through by refining the process of setting lending interest rates by banks. The system has transited from the prime lending rate (PLR) system (1994) to the benchmark prime lending rate (BPLR) framework (2003), the base rate mechanism (2010), and the present marginal cost of funds based lending rate (MCLR) (2016).

Under MCLR, banks are required to determine their benchmark lending rates, taking into account the marginal cost of funds -- unlike the base rate system where banks had the discretion to choose between the average cost or the marginal cost or blended cost of funds. Lending rates were expected to be more sensitive to the changes in the policy rate under the MCLR system.

The actual lending rate is based on MCLR plus a spread -- business strategy and credit risk premium. While the spread over the MCLR was expected to play only a small role in determining the lending rates by banks, it has turned out to be the key element in deciding the overall lending rates.

How has been the transmission in recent times?

Transmission of the cumulative reduction of 50 bps in the policy repo rate in February and April 2019 was 21 bps to the weighted average lending rate (WALR) on fresh rupee loans. However, the WALR on outstanding rupee loans increased by 4 bps as the past loans continue to be priced at high rates.
First Published on Jun 7, 2019 03:08 pm
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