India Economy

Interest rate transmission and beyond

SA Raghu | Updated on January 09, 2018 Published on October 29, 2017

Natali_ Mis/   -  Natali_ Mis/

There’s more to the issue than whether RBI pegs rates to internal/external benchmarks

Weak interest rate transmission has long been a concern for the RBI, understandably, because of the incessant pressure on the central bank to reduce interest rates. Thus, even after interest rates were deregulated in 1994, the RBI has been constantly trying to find the right rate fixing method for banks, which would seamlessly transmit policy rate changes.

Having realised that none of them have worked well, the RBI’s committee, which went into the entire gamut of transmission, has now come up with recommendations for linking lending rates to an external benchmark.

What hinders transmission

The report has an excellent analysis of the transmission under the various methods so far and lists many factors that have hindered transmission. These range from the excessive flexibility that the methods offered, to banks making offsetting changes in spreads to counter base rate reduction and to even simply a reluctance to reduce rates when costs dropped.

It appears that the RBI has now realised that internal benchmarks will not do the trick, probably why the committee recommends an external benchmark.

After analysing various rates, it shortlists three — the T-Bill, CD and Repo rates — as possible benchmarks but appears to be inclined towards the Repo rate as best suited.

The real issues

But the real questions go beyond the mechanics of transmission.

Should the central bank intervene in banks’ rate fixing, especially in a deregulated system?

Do interest rates impact the economy as much as they are stated to? To the first question, the committee does introspect, drawing upon the experiences in other countries but concludes that it would be in order for the RBI to do so. In fact it clearly places the onus of ensuring transmission on the RBI, because markets have failed to provide reliable benchmarks.

As to the second question, the theory behind transmission runs as follows; there are two channels in the economy, viz. the finance and the banking channels, through which rate transmission operates.

In the former, interest rates impact financial asset prices and returns and, in turn, influence the spending decisions of firms and households. Interest rates also impact exchange rates in open economies with floating exchange rates; the ebb and flow of foreign capital, attracted by differential interest rates, cause exchange rates to fluctuate, in turn impacting domestic liquidity and trade. The “credit” channel, on the other hand, works through corporate balance sheets and bank lending. The balance sheet is a theoretical construct based on the concept of a premium that borrowing requires over ‘internal resources’ for financing an investment and which exists because of ‘frictions’ in financial markets, such as imperfect information or costly contract enforcement.

A contractionary monetary policy, by increasing the external finance premium, supposedly reduces credit availability in the system. The bank lending channel is essentially the balance sheet channel applied to banks.

In countries such as the US, the bank lending channel has diminished in importance while the interest rate channel has been more influential. This is probably why the Fed had to design non-standard monetary actions when interest rates were near zero, focusing on financial asset prices rather than the quantum of credit.

Pulls and pressures

We have a bank-led financial system in India, which means rate transmission depends heavily on the banking rather than the finance channel. So , interest rate policy is almost entirely focused on influencing bank lending. The exchange channel is also weak since we have only limited integration with international financial markets. The combination throws up conflicting pulls and pressures — a liquidity surplus situation warrants interest rates to fall but high NPA levels and risk premium keep lending rates high.

Likewise, excess liquidity from foreign capital inflows causes rupee appreciation and hurts exports, leading to the clamour for rate reduction. The key issue then would be the link between official rate, bank rates, savings and credit. But data does not seem supportive. When the weighted average lending rates of banks fell from around 12 per cent in 2014 to 9.7 per cent in 2016 (with repo rate dropping from 8 per cent to 6.25 per cent), growth in bank credit to industry actually fell from 13 per cent in 2014 to 2.7 per cent in 2016 and to a negative 1.9 per cent in 2017. The opposite was true on the deposits side; low (savings deposit) or falling (time deposit) rates over the last two decades did not deter overall deposits growing at a compounded 15 per cent annually.

Clearly, more important factors are at work in investment and savings decisions. Further, the homogeneity, the risk aversion, the absence of a market mechanism (for instance, a term structure for interest rates) are characteristics of our banking system that could still hamper transmission, irrespective of whether benchmarks are internal or external.

The writer is an independent consultant

Published on October 29, 2017

A letter from the Editor

Dear Readers,

The coronavirus crisis has changed the world completely in the last few months. All of us have been locked into our homes, economic activity has come to a near standstill. Everyone has been impacted.

Including your favourite business and financial newspaper. Our printing and distribution chains have been severely disrupted across the country, leaving readers without access to newspapers. Newspaper delivery agents have also been unable to service their customers because of multiple restrictions.

In these difficult times, we, at BusinessLine have been working continuously every day so that you are informed about all the developments – whether on the pandemic, on policy responses, or the impact on the world of business and finance. Our team has been working round the clock to keep track of developments so that you – the reader – gets accurate information and actionable insights so that you can protect your jobs, businesses, finances and investments.

We are trying our best to ensure the newspaper reaches your hands every day. We have also ensured that even if your paper is not delivered, you can access BusinessLine in the e-paper format – just as it appears in print. Our website and apps too, are updated every minute, so that you can access the information you want anywhere, anytime.

But all this comes at a heavy cost. As you are aware, the lockdowns have wiped out almost all our entire revenue stream. Sustaining our quality journalism has become extremely challenging. That we have managed so far is thanks to your support. I thank all our subscribers – print and digital – for your support.

I appeal to all or readers to help us navigate these challenging times and help sustain one of the truly independent and credible voices in the world of Indian journalism. Doing so is easy. You can help us enormously simply by subscribing to our digital or e-paper editions. We offer several affordable subscription plans for our website, which includes Portfolio, our investment advisory section that offers rich investment advice from our highly qualified, in-house Research Bureau, the only such team in the Indian newspaper industry.

A little help from you can make a huge difference to the cause of quality journalism!


Support Quality Journalism
This article is closed for comments.
Please Email the Editor
You have read 1 out of 3 free articles for this week. For full access, please subscribe and get unlimited access to all sections.