On August 21, as recommended by the Monetary Policy Committee, the Reserve Bank of India reduced the repo rate by 35 basis points. In continuation of this, the RBI Governor said that banks should speed up the process of shifting to an external benchmark on rates.

Finance Minister Nirmala Sitharaman, on her part, said that banks should be more reasonable in passing on interest rate cuts to the customer — that is, the borrower. She said that it has been a common grievance across segments that benefit of the various rate cuts by the RBI is not reaching the customer, and even if it does “it trickles down over months and years.”

Rate of interest and growth

The general expectation is that whenever the cost of borrowing is reduced, it will encourage more borrowing, more investment and growth. But is it true?

In an empirical examination of the relationship between interest rates and nominal GDP growth in the US, the UK, Germany and Japan, it was concluded that conventional monetary policy as operated by central banks for the past half-century is fundamentally flawed.

On examining the relationship between three-month and 10-year benchmark rates and nominal GDP growth over half a century, in four of the five largest economies it was found out that interest rates follow GDP growth and are consistently positively correlated with growth. If policymakers really aimed at setting rates consistent with a recovery, they would need to raise them.

Repo rate is the rate at which banks borrow from the RBI to meet their day-to-day asset-liability mismatch and this is granted against government securities in which the banks have invested. The amount of such borrowing is negligible. As on July 19, 2019, it was hardly 0.35 per cent of banks’ loan portfolio.

It can also be observed that banks’ credit balance with the RBI is much more than their borrowing from the RBI at any point of time. This means that RBI is meeting the requirement of some banks out of funds provided by other banks.

The RBI expects banks to have the repo rate as a benchmark for lending rate. A benchmark can be a point of reference by which something can be measured only if there exists some relationship between the two. When banks are not even getting one per cent of their funds requirement from the RBI at repo rate, how can repo can be a benchmark?

If banks reduce the interest rate on loans without a corresponding reduction in deposit rates, it will be disastrous. If deposit rates are reduced, then the household savings rate, which is already dwindling, will come down further and banks will find it difficult to mobilise funds. Moreover, interest can be reduced only for fresh or renewed deposits. The policymakers also talk about ‘transmission’ of interest rates. This is another misconception. How can cost of funds for one per cent of required funds be transmitted for hundred per cent of loans?

Banks have been arm-twisted to provide repo-rate linked consumer loans recently. But it is illogical to lend at a rate which is in no way related to the cost of funds of banks. As part of financial liberalisation, the RBI had long back allowed banks to decide the interest rate on deposits and loans, barring those to the priority sector. Now pressuring banks to tune in with the repo rate amounts to going back to the days of administered rates.

The writer is a retired banker

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