Contents
Context
After a rate hike of beyond 6.5%, RBI tightened its monetary policy. Unprecedented hikes of rates put unwarranted risk to the growth of the economy.
What is Monetary Policy?
Monetary policy refers to the actions taken by a central bank, such as the Reserve Bank of India (RBI), to regulate the supply and demand of money and credit in the economy. The goal of monetary policy is to achieve price stability, economic growth, and financial stability.
The monetary policy instruments used by RBI are Repo and Reverse repo. The repo rate is the rate at which the RBI lends money to commercial banks. On the other hand, the Reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country.
What is Monetary Policy Transmission (MPT)?
The process through which the central bank’s policy action is transmitted to the final objective of stable inflation and growth is called as Monetary Policy Transmission.
The policy action consists of measures such as: changing the interest rate at which the central bank borrows or lends “reserves”(Rupees) on an overnight basis with commercial banks.
Thus, monetary policy transmission is the entire process starting from the change in the policy rate(repo rate) by the central bank to various money market rates (e.g- inter-bank lending rates, to bank deposit rates, bank lending rates) to households and firms, to government and corporate bond yields and asset prices (stock prices and house prices). It is expected to finally result in stable inflation and economic growth.
Role of RBI in Monetary Policy Transmission
In India, the RBI (Amendment) Act, of 2016 mandated the RBI to frame monetary policy with an aim to maintain price stability while keeping in mind the objective of growth.
The Monetary Policy Committee (MPC) constituted under the amended RBI Act was mandated to determine the policy repo rate to achieve the specified medium-term inflation target of 4 per cent, within a band of +/- 2 per cent.
For the Reserve Bank to achieve its mandate effectively, monetary policy transmission should work seamlessly. Any impediment to this process of monetary transmission hampers the achievement of RBI’s mandate.
Therefore, RBI monitors monetary policy transmission on a regular basis and undertakes corrective steps to enhance its efficacy, if it seems imperfect.
Role of banks in Monetary
The change in the policy rate by the central bank is expected to impact the banks’ cost of funds and lending rates of banks. For instance, lowering of policy rates by the central bank is expected to lead to a reduction in the loan interest charged by the commercial banks, leading to lower borrowing costs for the bank customers and an increase in aggregate demand.
What is the actual lending rate of banks?
In India, a large proportion of loans are based on floating interest rates [Floating Interest rates means that the rates charged to the borrower keep changing depending on a reset clause. The reset clause determines the period after which the interest rates of the banks are reset].
The floating rates, in turn, are linked to some benchmark rates. The benchmark rate varies over time depending upon changing macroeconomic conditions, financial conditions and the central bank’s policy rate. The benchmark rate may be of two types:
- Internal Benchmark: It is calculated based on factors which are in control of the banks (e.g- the cost of funds, operational costs etc.) All the interest rate regimes of India have been based on an Internal benchmark (e.g BPLR, MCLR etc).
- External Benchmark: It is calculated based on factors which are market-determined and are not under control of banks.
Banks, then charge a spread (based on factors such as credit risk) over the benchmark rate to determine the actual lending rate.
Thus, Actual lending rate = Benchmark Rate + Spread
Evolution of Bank Lending Rates
1969-1994: Nationalisation of banks and the government-administered interest rates on them.1994-2003: Prime Lending Rate system was introduced after the recommendations of the deregulation of interest rates by the Narasimham Committee in 1991. According to it, the government no longer decided the lending rates of banks. RBI gave only the methodology of calculating the lending rates to banks.
2003-2010: The benchmark prime lending rate (BPLR) system was introduced, according to which the reference lending rate was benchmarked against rates at which the commercial banks were expected to charge their most credit-worthy customers.
2010-2016: Base rate system was introduced. The base rate is the minimum rate below which the individual banks cannot lend to their customers, except in cases allowed by the RBI. Lending rates of banks are then determined by adding a suitable spread to the base rate. Individual banks fixed their own base rate. So, each bank had its own base rate.
2016-Present: Marginal cost of funds-based lending rate (MCLR) system replaced the earlier system to ensure
effective monetary policy transmission. It is the minimum interest rate below which the banks cannot lend (except in some cases allowed by the RBI).
MCLR is a tenor-linked internal benchmark, which means the rate is determined internally by the bank depending on the period left for the repayment of a loan. Marginal Cost refers to the additional cost of arranging one more rupee for the prospective borrower.
Reasons for lag in Monetary Policy
1. Low dependency on Repo Rate: The Indian financial system is dominated by banks. The banks play the primary role in mobilising household savings (due to a lack of a well-developed bond market and low investments in corporate bonds, equities etc). Thus, the banks are not dependent on the repo rate facility of RBI.
2. Rigidity in the interest rates of banks: An internal study group of RBI has highlighted that a major reason for the weak transmission of policy rates was the rigidity in interest rates on banks’ saving deposits. The interest rate on it remained highly stubborn even as the policy repo rate and interest rates on term deposits moved in either direction.
3. Double Financial Repression: The 2015 Economic Survey pointed out to the double financial repression plaguing the Indian banks. Double financial repression refers to the problem faced by the banks on the asset side as well as the liability side
- Asset-side: High Statutory Liquidity Ratio has resulted in the locking of banks’ funds in government securities. Priority Sector Lending norms have also impeded the banks’ lending to the productive sectors.
- Liability Side: Low deposit growth has created repression on the liability side. Banks need deposits to cater to the credit demand. However, due to low household savings, cheaper credit to banks is not available. Thus, the banks are reluctant in passing the rate cuts to the customers.
4. NPAs in the banking sector: Low levels of asset quality and high levels of NPAs of public sector banks have hampered the ability of banks to offer low-interest rates.
5. Administered interest rates:
- Small-savings schemes have government-administered interest rates. They offer higher interest rates than banks. It has impacted the portfolio decisions by households and resulted in lower deposit growth, adding to the liability-side repression.
- Further, the banks have often reasoned that the high small savings interest rates make it difficult for them to cut term deposit rates.
6. Issues in the MCLR system: RBI’s Internal Study Group chaired by Dr Janak Raj has highlighted the following issues with the MCLR system:
- Transmission under the MCLR system has been slow and incomplete.
- Transmission has been significant for new loans but has had no effect on the outstanding loans.
- The transmission was uneven across borrowing categories.
- The transmission was asymmetric across monetary policy cycles. (For instance-higher during the tightening phase and lower during the easing phase, irrespective of the prevailing interest rates.)
7. Arbitary calculations: The RBI’s Internal Study Group recognised that arbitrariness in calculating the base rate/MCLR and spreads charged over them has further undermined the integrity of the interest rate-setting process.
8. Lack of competition in the banking sector:
- India is a bank-dominated economy. But the number of banks have remained stagnant over the years. The banking ecosystem is dominated by public sector banks that lack competitive spirit and are burdened with NPAs.
- Private and foreign banks have faced a number of entry barriers in India. The small number of banks in the economy has negatively affected competition among the existing banks, who haven’t felt the necessity to pass on the rate changes to the final consumers.
Impact of lag in Monetary Policy Transmission
1. Less borrowing: Effective transmission of a reduction in the repo rate results in low lending rates for loans. This leads to less borrowing costs for firms and households. Thus, a lack of adequate transmission results in less borrowing.
2. Impedes economic growth: Lack of effective transmission of rate cuts to customers may reduce spending by them. Thus, it may reduce consumption and may lead to an economic slowdown.
3. Deters investment: A lag in passing on the rate cuts to the household and firms affects investor sentiment negatively. Thus, it may reduce the amount of investment by private firms.
4. Ineffective RBI policies: RBI changes the policy rates to fulfil its mandated aims of containing inflation and spurring economic growth. [For instance, RBI may reduce the repo rate to make borrowings cheaper, raise the demand in the economy and thus tackle an economic slowdown.] Thus, banks not following the policy rates may render RBI policies ineffective.
5. May hamper export competitiveness: A smooth rate-cut transmission (i.e, low domestic rate of interest) would lead to a depreciation of the domestic currency and a rise in demand for exports in the global market. However, a lack of it would hamper export competitiveness.
6. Impact on the retail/SME borrowers: Most of the base rate customers are retail/SME borrowers. Hence, the banking sector’s weak pass-through to the base rate has turned out to hamper the retail/SME borrowers in an easy monetary cycle. This was highlighted by an RBI report.
Way Forward
1. External benchmark-based lending rate system:
- External benchmark-based lending rate systems are in line with global best practices.( For example, the pricing of bank loans based on the London Interbank Offered Rate)Thus, India should consider migrating to such a system.
- The Internal Study Group of RBI had recommended the suitability of the TBill rate, the CD rate and the Reserve Bank’s policy repo rate to serve as an external benchmark.
2. Resolving the NPA crisis: Early resolution of the NPA crisis of the banks would increase the banks ability to effectively pass on the rate cuts to the customers.
3. Dealing with asset side repression: A reassessment of the PSL norms based on the current economic scenario
and easing the SLR obligations of the banks may alleviate the asset-side repression of the banks.
4. Deregulation of the interest on small saving funds: Y V Reddy Committee and Shyamala Gopinath Committee had recommended that the small savings rate be determined through market-based mechanisms. This would provide a boost to the bank deposits.
5. Targeting the loans linked to the base rate: The Internal Study Group of RBI has recommended the banks recalculate the base rate by removing/readjusting arbitrary and entirely discretionary components added to the formula that is used to calculate base rate.
6. Migrating to MCLR system: An RBI working group has advised the commercial banks to allow existing borrowers to migrate to the MCLR if they so choose to do without any conversion fee or any other charges for switchover on mutually agreed terms.
