Monetary policy actions are transmitted to the economy through their effect on market interest rates. A policy rate hike by the central bank pushes up both short-term and long-term interest rates, leading to less spending by interest-sensitive sectors of the economy such as housing, consumer durables, and business fixed investment. Conversely, a rate cut results in lower interest rates that stimulate economic activity.
Monetary easing and credit growth in India
This standard theory does not seem to have worked for our economy. RBI, since January 2015, has shifted to an accommodative policy stance. There were four rate cuts in 2015, cumulating to 125 basis points (bps). This large reduction in repo rates, from 8% to present level of 6.75%, has failed to boost economic activity as indicated by the sluggish credit growth. In fact, bank credit growth, which stood at 10.2% in December 2014, languished further to 8.8% in October 2015 despite the reduction. However, since October 2015, we do see some improvement in credit off-take and the growth rate has improved to 10.9% in January 2016.
Many commentators have tried to explain that this sluggish growth in bank credit is due to (a) incomplete transmission of the monetary policy as banks have not passed on the entire benefit to the borrowers; (b) unwillingness of the banks to lend on account of rising NPAs; (c) worsening balance-sheets forcing corporates to put their investment decisions on hold; and (d) interest rates in the bond market have been more attractive for borrowers.
Long-run interest rate and monetary transmission
But little attention has been paid to the behaviour of the long-term interest rates since the rate cut. One of the objectives of a policy rate cut is to reduce long-term interest rates—say G-sec yields in the case of India—as international experience suggests that decline in long-term interest rates helps stimulate bank loan supply.
Banks in India hold most of their investments in two kinds of assets: loans and G-secs. A change in the yield of G-sec affects bank loan supply via two transmission channels. The first channel is what we will call the “portfolio balance channel.” In response to the decline in G-sec yield, a bank will increase its loan supply because the decrease in income from bond holdings makes it more profitable for the bank to hold loans. The second channel is the “bank balance-sheet channel”. When interest rates fall and securities’ prices go up, a bank’s net worth increases through the capital gains on the bonds that it holds. A stronger balance-sheet allows the bank to increase its loan supply. Thus, both the channels help stimulate bank credit in response to long-term interest rate reduction.
Empirical evidence from India
While the relationship between policy and long-term interest rates appears much looser and more variable, a casual observation suggests a close connection between RBI actions and short-term interest rates. The accompanying chart depicts how short-term and long-term interest rates have behaved in response to similar policy rate changes in two different periods. Starting December 2011, RBI embarked on an accommodative policy stance and had cut repo rate by 125 bps by June 2013. The rate cut was reflected in the short-term as evident from similar reductions in Treasury bill yield of different maturities. The policy rate cut was also successful in reducing the long-term interest rate as 10-year G-sec yield declined by 103 bps. In contrast, the recent episode of repo cut has been successful in bringing the short-term interest rates down but it has failed to reduce the long term interest rate—10-year G-sec yields have only declined by 25 bps in response to 125 bps cut in repo rate.
Impact of PPF rate cut and fiscal consolidation
This failure of monetary policy to reduce the long-term interest rate is partly responsible for bank credit growth not picking up to the desired level. However, there are indications that G-sec yield may not remain at its current high level.
First, the government has stuck to its commitment of fiscal consolidation in the FY17 budget. This will reduce the supply of G-secs, which remains at high level now. As per CCIL data, there was a net supply of R75,000 crore of government securities. This high supply is one of the reasons why G-sec yields have not come down even after the repo cut. Fiscal consolidation will bring down the government borrowing and hence the issuance of G-secs. A reduction in supply will push up prices of previously issued securities and hence yield may come down.
Second, the government has cut the interest rates on the public provident fund (PPF) and other small savings schemes run by the post office. Banks compete with these schemes for deposits and given the high interest on offer on post office savings schemes, banks could not cut interest rates beyond a point without losing out on deposits. Time deposits are the cheapest source of credit available to banks and a fall in time deposits growth, which is already at historical lows, may create liquidity crunch in the market. The move to cut the interest rates on PPF and other small savings schemes may help grow the time deposits. Part of this extra liquidity will help banks increase loan supply as well as investments in G-sec. This increased demand for G-secs will in turn push up prices and yields may come down which may further incentivise banks to divert their investments towards loan supply.
The author is with the Indian Economic Service and is a research officer at the department of economic affairs, ministry of finance.
Views are personal