The lay observer wouldn't be faulted for thinking more than half of all stories in the pink papers are about the Reserve Bank of India's interest rates: Businessmen (and the finance minister) demanding cheaper rates, economists arguing that this will cause inflation and analysts hedging. The Economic Survey of India, tabled before the Budget in February, chose to ask a more fundamental question: Do RBI rate cuts actually matter?
The question is obviously a short-term one, which remains pertinent after RBI Governor Raghuram Rajan on Tuesday again announced a cut in the key interest rate to 6.5%.
In the medium- and long-term, the central bank's lending rate sets the benchmark for those offering loans across the country. Lower rates means more cash in the economy, and vice versa.
Yet most of the pink paper-commentary tends to focus on the immediate gains that could come from a rate cut, with the presumption that lower RBI interest rates automatically mean higher growth.
This premise is based on two invisible steps that come in between those two events. First, that the RBI lowering its lending rate will cause other banks to make credit cheaper as well. And second, that the availability of cheaper loans will spur industrial and consumer activity.
Policy gap
The Economic Survey of India pointed out that the first of those steps seemed to be missing altogether.
"In 2015, there were no less than four rate cuts cumulating to 125 basis points, including a 50 basis point cut at the October meeting," the survey said. "But there has been much less “accommodation” in bank lending rates, which have only fallen by around 50 basis points."
Or in other words, the RBI has been lowering its rates – the blue line in the above graph – but banks haven't been following suit with the same enthusiasm, as the red line demonstrates. There has always been a gap between the two rates, but, worryingly, that chasm seems to have gotten wider.
So even if all the pink papers get their way and see the RBI lower its rate, as it did on Tuesday, that still doesn't always translate into easy money.
"Given weak private investment in the face of low capacity utilisation, a reduction in the policy rate by 25 bps will help strengthen activity and aid the Government’s initiatives," the review stated. "Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates."
Since February, both the government and the central bank have been making a concerted effort to ensure that rate cuts are actually effective weapons in attempting to steer the economy.
Smaller savings
To do this, they have had to attack the reasons why the RBI's rate cuts are not being reflected by banks.
First, there are the small savings schemes. Many analysts believe that even if the RBI has lowered its interest rates, banks are reluctant to do the same out of a fear that customers will simply flock to the government's various schemes – like the Public Provident Fund and the Kisan Vikas Patra – which offer reliable yields.
Even though the Survey said that this was not the reason rate cuts weren't being transmitted into the economy, the government in March cut the rates for all of these schemes. It also announced that the rates will be reviewed every quarter, instead of annually, to ensure they aren't holding the economy back.
Liquid money
The survey pointed out that, even as the RBI lowers interest rates, actual liquidity in the market has tightened for a number of reasons. In its first monetary policy review of the new financial year, the central bank announced a number of changes to its liquidity policies to make it easier for cash to flow around.
For example, the RBI reduced the daily cash reserve banks have to maintain, lowered the penalty for banks borrowing above their quota, announced a Rs 15,000-crore infusion of funds into the system and said that it would no longer maintain a slight deficit of liquidity.
In other words, the RBI has done its job – lowering its rates – and then done it twice over, ensuring that there is plenty of liquidity in the system. The banks no longer have any excuses.
"Now we have given them more liquidity, so transmission should take place,” Rajan told reporters after the policy statement was released, according to the Business Standard. "There will be no uncertainty about liquidity now.”