Bank Report

Urjit Patel debuted with a rate cut but even he knows your EMIs may not come down any time soon

The Reserve Bank, the government and industry are all keenly watching how much of the benefit banks will pass on to consumers.

Like a top-order batsman sent out to accelerate the run rate after a slow first few overs in a Twenty20 match, Reserve Bank of India Governor Urjit Patel debuted with a six – well, almost. Patel headed the first meeting of the Monetary Policy Committee on Tuesday and decided to slash the repo rate by 0.25% to bring it down to 6.25% in light of sustaining growth in the economy as demand and investment slow down. But, will Patel's opening stroke prove enough to cement a strong innings?

The repo rate is the rate at which the RBI lends to banks and as this rate gets lower, banks get cheaper and greater access to credit that they are then expected to pass on to their customers in the form of lower interest rates on their loans.

Patel’s predecessor at the central bank, Raghuram Rajan, had held off on cutting rates despite being persistently nudged to do so by markets and politicians. Citing inflationary pressures, he had maintained that rate cuts would come only after inflation was brought under check.

Now, his successor and former deputy has gone ahead and made the cut. But nobody is sure if and when it will have the desired impact on the economy.

Inflation watch

Many Rajan critics, batting for lower rates while citing growth concerns, argued that rate cuts would prompt banks to lower interest rates on lending. That, subsequently, would make it easier for businesses to finance their projects and get investment going. But that is just bad economics in the long run since sustained inflation for a period of time can stifle growth rather than boost it.

Patel knows this well. That is perhaps why, when he made the rate cut on Tuesday, he also cautioned against future inflation risks. He said the easing of the monetary policy stance should not be seen as a regular feature of the RBI’s bi-monthly review as inflation has to be watched closely.

However, he indicated that the RBI would seek to achieve an inflation rate of 4% with a margin of 2% on either side in the medium term, that is, 2021, implying that expectations of taming inflation before 2018 stood null and void, according to a report in The Hindu.

Passing it on

Corporate executives and rating agencies are cheering the rate cut, hoping it will transmit to the financial economy and people will have more money in their hands to spend by the end of the year. But this has never proved easy – banks tend to be reluctant to cut rates as fast as the RBI would like them to.

Voicing this concern, Patel said, “I agree that the transmission to bank lending and to bank borrowers has been less than any one of us would have liked.”

However, he expressed hope that with the new measures introduced by the central bank – such as the Marginal Cost Lending Rate or MCLR – the rate cuts would transmit better in the near future. “We are hoping that over the next quarter or two, keeping in mind that the government has also reduced the small savings rate, the MCLR calculation will throw up more transmission.”

This was something that haunted Rajan as well. According to the Economic Survey of India, 2015, banks dropped their rates by only 50 basis points when the RBI cut rates by 150 points. “Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates,” the survey said.

While the RBI would like banks to transmit rates as soon as it cuts or raises them, the banks remain non-committal. Even the government-run State Bank of India said it would ease rates based on the “evolving liquidity situation”.

“The committee’s decision to cut the repo rate by 25 basis points was on expected lines, and with benign inflation trajectory going forward, the RBI’s policy stance is expected to remain accommodative,” SBI chief Arundhati Bhattacharya said. “Banks will continue to transmit rates based on the evolving liquidity scenario.”

According to experts, one reason for the slow transmission of monetary policy in the economy is the small savings rate. They said schemes such as the Kisan Vikas Patra turn out to be relatively more lucrative when interest rates on bank deposits go down – something the banks don’t want.

The government, however, has been working to review the small savings rate more often and it cut rates for provident fund by a marginal 0.1% just last week, the second cut this year after a more substantial slash earlier in the year.

The RBI, on its part, hopes that there are reasons beyond the small saving deposits that prompt bankers to cut rates.

“The easy liquidity conditions engendered by the Reserve Bank’s operations should also enable the smooth transmission of the policy action through various market segments,” the RBI said in a statement. “Furthermore, banks should find added impetus for better transmission by the recent downward adjustment in small savings rates.”

Even industry is looking to the banks in anticipation of rate cuts being transmitted quickly.

“The rate cut should spur growth and the corporate sector should see it as an encouraging move to foster investment,” Deepak Premnarayen, president of the Indian Merchants Chamber, told Firstpost. “However, the speed of transmission of this rate cut would be an important determinant.”

Challenges

But, the road to actual rate cuts isn’t as easy as it seems. In August, it was reported that the RBI would come up with a new formula to derive lending rates through the Marginal Cost of Lending Rate, which impacts the rate of deposits. According to SBI’s Bhattacharya, 40% of deposits are in savings or current accounts that are interest-rate agnostic, implying that they don’t transmit RBI rate cuts. Hence, the remaining 60% of deposits is where there is scope to cut rates.

“So, since there has been a rate cut of 150 basis points and if you multiply by 60%, then we have already passed on 90 basis points. So, whatever could be passed on, we have already passed on,” she told the Hindu in August. “Transmission is not something that is a one-on-one relationship. It has to happen keeping a lot of things in mind.”

Studies suggest there could be other reasons why the RBI rate cuts do not get transmitted. According to one study published by researchers from the Indira Gandhi Institute of Development Research, the formal banking sector is grossly limited in its reach and hence transmission, even if it happens, is unlikely to change the level of aggregate demand in the economy to a great degree.

“The small size of that [formal banking] sector limits the reach of the monetary policy, thus reducing its impact on the economy,” the study noted, adding that whenever it can reach the customers, the costs are too high for financial intermediation to actually reflect monetary policy changes.

“The second [reason] is that costly intermediation likely implies a sharply rising marginal cost of intermediation as banks try to serve smaller and more opaque borrowers, so even for the share of the economy that is served by the formal financial sector, central bank actions may have weak effects on the supply of bank lending.”

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