News Analysis

What ails transmission of RBI’s monetary policy?

Radhika Merwin BL Research Bureau | Updated on April 05, 2019 Published on April 05, 2019

Lending rate structure, tight liquidity, and hardening bond yields impeding pass-through of the RBI’s policy action

When the RBI had proposed external benchmark rates in place of bank-specific benchmarks in its December 2018 policy, there were expectations that this would improve transmission of policy rates.

But given the challenges in the structure – managing earnings volatility (interest-rate risk) on account of asset-liability gaps – the RBI has deferred implementing it.

This brings the focus back on the existing challenges in monetary policy transmission that can lead to a slow pass-through of RBI’s rate cut – 50 bps in all this year – with the latest April policy cut of 25 bps.

While inherent structural issues with the fixing of lending rates by banks remain a key impediment, persisting liquidity constraints in the banking system are accentuating the problem.

Weak transmission is not a new animal. Right from the pre-PLR (prime lending rate) era, banks have been tardy in passing on the RBI’s rate action. In a bid to smoothen transmission issues, the regulator has been revamping the interest rate structure for many years now.

There are predominantly two reasons for weak transmission.

One, banks source only a minuscule portion of their funds (1 per cent) from the repo window, and rely significantly on longer term deposits; only 50-60 per cent of banks’ funding gets re-priced.

Hence, a cut in the repo rate, does not immediately reduce costs for banks.

Under the erstwhile base rate, when most banks followed the average cost of funds method to set their base rates, deposits were unaffected by rate changes, thus limiting changes in lending rates.

Under MCLR, banks are mandated to calculate cost of funds based on the latest rates offered on deposits or borrowings.

This does ensure quicker changes in deposit rates, and hence, lending rates but ad-hoc practices followed by banks while fixing lending rates under the MCLR, have led to a wide set of transmission issues as was highlighted by the RBI in an earlier report.

Setting an external benchmark could have helped tackle some of these issues. For now, the structural impediments in the MCLR structure will continue to delay transmission.

The second reason was unfavourable liquidity conditions.

If a bank is facing a liquidity crunch, it is unlikely that it will lower deposit rates in a hurry when the RBI reduces its policy rate. Hence, banks will be forced to keep deposit rates high, giving them no relief on the cost front; the ability to lower lending rates without hurting margins is hence difficult.

The persisting tight liquidity condition is further weakening the transmission of policy rates.

The recent increase in currency in circulation has led to squeezing of liquidity from banks. Currency in circulation now stands at ₹21.15-lakh crore; it was ₹17.6-lakh crore in November 2016 before demonetisation.

Data from 2007 show that the currency in circulation grew by 14 per cent annually (compounded annual growth) until March 2016. Notes in circulation were 11-12 per cent of nominal GDP. Post-demonetisation, this ratio had dipped to 8-10 per cent as of March 2017 and March 2018, leading to a cash crunch.

Over the past year, there has been a significant increase in currency in circulation – a 17 per cent growth in FY19. Considering the pace of economic activity, this would not seem out of sync, as notes in circulation are now 11 per cent of the nominal GDP (if one were to go by CSO estimates), back to pre-demonetisation levels. But this increase in currency circulation has led to a liquidity squeeze.

High credit-deposit ratio

After deposit growth spiked and credit growth slipped to 5-7 per cent levels post-demonetisation in November 2016, the credit-deposit ratio fell to 71-73 per cent, implying that banks were able to deploy only ₹71-73 out of every ₹100 deposit as loans.

Since December 2017 quarter, credit-deposit ratio has been on the rise, though.

As of December 2018 quarter, credit-deposit ratio was 77.6 per cent; latest available data (as of March 15, 2019) suggest that the ratio has inched up further to 78 per cent, indicating the pressure on banks’ resources.

The 10-year G-Sec yield has been trading in a very narrow range of 7.3-7.4 per cent since February, despite RBI’s February rate cut.

This is because the 24 per cent jump in gross market borrowings to ₹7.1-lakh crore in the Interim Budget 2019-20 has kept markets wary. Even after the RBI’s Thursday rate cut, bond yields have only inched up by about 6 basis points. This is because the RBI has not changed its stance from neutral to accommodative. An accommodative stance would have increased the probability of more rate cuts.

A sticky bond yield indicates that borrowing costs for corporates will remain high, leading to bumpy transmission of RBI’s policy action.

Published on April 05, 2019
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