1. RBI review: What Rajan needs more than an effective monetary transmission policy

RBI review: What Rajan needs more than an effective monetary transmission policy

Today, the Reserve Bank of India (RBI) will announce its first bimonthly monetary policy for fiscal 2016-17. The expectation is that RBI will cut the policy repo rate by at least 25 basis points (bps).

By: | Updated: April 5, 2016 11:09 AM
Raghuram Rajan RBI has already cut the repo rate by 125bps since January 2015. However, the rate transmission to the consumers has not been very effective.

Today, the Reserve Bank of India (RBI) will announce its first bimonthly monetary policy for fiscal 2016-17. The expectation is that RBI will cut the policy repo rate by at least 25 basis points (bps). Analysts and bankers argue that the stage is right for another set of rate cut, given the fact that inflation has come down and the government has stuck to its commitment of fiscal consolidation in the recently announced Union Budget. Further, the decision of the government to cut interest rates on its savings schemes put the ball back in the court of RBI to reduce the policy rate to provide a boost to the economy.

RBI has already cut the repo rate by 125bps since January 2015. However, the rate transmission to the consumers has not been very effective. The average lending rate of scheduled commercial banks has come down by only 70bps in response to the four rate cuts cumulating to 125bps. This ineffective transmission has largely been blamed for muted bank credit growth, which has generally been sub-10% for greater part of last one year.

Is it just the ineffective transmission of monetary policy which is responsible for the sluggish credit offtake? What if everything falls in place and the transmission is perfect? Will it necessarily lead to a surge in credit growth? Perhaps not. Remember that the pace of credit growth is largely constrained by the deposits with the banks, especially time deposit. According to the latest RBI data, time deposit growth has fallen to 9.9% as on March 18, 2016, which is the lowest since 1963.

bank

Time deposits still remain the most important source of bank funding. In addition, time deposits are cheaper relative to other sources of funding and allow banks to afford higher interest spreads. It is no wonder that slowdown in time deposits has been slowing the growth of bank credit as well.

As can be seen in the accompanying chart, except for the period May 2004-April 2007, credit growth has remained close to time deposit growth. But what explains this high spread between time deposit growth and bank credit growth for the period May 2004 to April 2007, and is it achievable again? The answer again is no. This was the period when, with the first signs of rising interest rates, Indian banks shifted focus from investment in government securities to loans.

As a result, the investment in government securities as a proportion of time deposit fell from 45% to 30%. On the other hand, the credit to deposit ratio surged from 55% to nearly 73%. Now, given that banks have already diverted a great part of their excess statutory liquidity ratio (SLR) holdings towards new loans, such a wide spread between time deposit growth and bank credit growth may not be witnessed any time soon.

It is in this context that it becomes important to revive the falling deposit rates, and not just wait for greater transmission of monetary policy to happen to boost the credit growth. It is crucial to analyse why deposit rates have reached such historical low levels, despite the real rate of interest on deposits turning positive in late 2013 after inflation dropped to below 9%.

The fact that the pace of growth of per capita income has slowed down in the last 3-4 years and households might be channelising their savings to avenues such as gold and real estate can only partly explain this conundrum. Also important has been the fact that savers have been parking their money with alternatives like post office-run small savings schemes that offer better returns.

So, how exactly can we provide a boost to falling deposit rates, which, in turn, may help push up the credit offtake and help spur industrial growth? Unfortunately, there is not much that the banks can do, as raising deposit rates in the current circumstances is not possible. It is here that a right mix of monetary and fiscal policies becomes important.

The government has moved in the right direction by cutting down the interest rate on its savings schemes. RBI may further complement the government’s efforts by reducing the minimum tenure of deposits from, say, 7 days to 3 days, which will make deposits more liquid. Today a very high proportion of household financial assets is held in cash, and making the deposits more liquid will help banks attract these resources.

The author is research officer, Department of Economic Affairs, ministry of finance. Views are personal

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