SLATE. All you wanted to know about: Monetary Transmission

Monetary transmission has been a hot-button issue in recent times. Industrialists have been asking the government to ensure it. The government has been chiding banks for the lack of it. And the Reserve Bank of India, in its policy announcement last week, said that quick monetary transmission was the pre-condition for further rate cuts.

Monetary transmission is the pass-through of the RBI’s rate actions to the economy at large. As you know, the RBI’s most important task is to keep tabs on inflation by adjusting money supply. It also monitors the exchange rate. To control all this, the RBI uses many monetary tools. The repo rate, reverse repo rate and cash reserve requirement are being the key instruments. Let us take the repo rate, for instance. This is the rate at which the RBI lends short-term funds to banks to manage their day-to-day operations. When the RBI wants to stimulate growth, it cuts the repo rate to reduce the cost of borrowings. Banks get money at a cheaper rate. If this is passed on to borrowers, then monetary transmission is said to have happened smoothly.

In reality, monetary transmission has not been so smooth. Banks have almost always been tardy in passing on the benefit of rate cuts to borrowers. To understand why, you need to know how banks price loans. Banks decide their lending rates based on something called a base rate, which is calculated through an RBI-mandated formula which factors in their cost of funds, administrative costs and profitability. This base rate is the bare minimum rate at which a bank can lend. Going by the method of computing base rate, it would be logical to assume that when the RBI cuts repo rates, this should lower cost of funds for banks and hence mean lower lending rates

But thanks to the bizarre workings of the base rate system, it doesn’t happen that way. The repo rate, banks protest, may be a signalling rate, but it has no direct link to their actual cost of funds. This is because they source only a minuscule portion of their funds from the RBI repo window. So every time the RBI cuts its policy repo rate, banks say, their costs are not really coming down. It is only when they cut deposit rates that you can hope for cheaper lending rates.

Did you blame the government or the RBI for not doing anything about runaway inflation a couple of years ago? Are you worried that the economy is not heading anywhere now? Well, then you should worry about monetary transmission. Apart from making the RBI policy ineffectual, the lack of monetary transmission also reduces the predictability in the movement of interest rates. If the central bank is signalling lower rates but banks aren’t acting to reduce their lending rates, you are left guessing every time the RBI makes its move. Worried about the lack of monetary transmission, the RBI has been quite critical of banks not slashing their lending rates in its latest policy. It has asked banks to review their formulae for calculating base rates. It has also opened a new term repo window to ensure that banks get to borrow at close to market rates.

The next time RBI governor Raghuram Rajan makes his policy statement, listen up. If he decides to cut policy rates, faster monetary transmission can make your loans cheaper. But the interest rates on your deposits can fall pretty quickly too. As they say, you win some, you lose some.

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