1. Why interest rates in India are best left to free market forces; competition, not diktat is the way forward

Why interest rates in India are best left to free market forces; competition, not diktat is the way forward

Interest rates are best left to competition and free market forces.

New Delhi | Published: October 13, 2017 3:52 AM
interest rates in India, India, economy Competition, rather than diktat, is the way forward in a market-driven economy.

If bankers in the country were hoping that their prayers would be answered and the RBI Committee on the Marginal Cost of Funds based Lending Rate (MCLR) would ditch the very concept of MCLR, they are in for a disappointment. The draft report of the Study Group (placed on RBI’s website after the monetary policy announcement last week) suggests the central bank has not understood the fundamental difference between the cost of funds for banks in advanced economies vis-a-vis banks in India.

In India, the main determinant of the cost of funds, and hence of banks’ lending rates, is the cost of bank deposits. In the West, in contrast, it is the cost of funds in the interbank market. And this makes all the difference. The suggestion to move to an externally-determined benchmark in the absence of such a market is like comparing apples and oranges. LIBOR (London Interbank Offered Rate) is not the same as MIBOR (Mumbai Interbank Offered Rate). And to gloss over the difference is to miss the woods for the trees.

More importantly, it is not possible to transplant a system that exists in the West to India, where the underlying economic system is vastly different. So, to argue, as the central bank does, that “the base rate/MCLR regime is also not in sync with global practices on pricing of bank loans,” is to miss the point completely. Unfortunately, in its obsession with improving ‘monetary transmission’, RBI has gone to the extent of accusing banks of “arbitrariness in calculating the base rate/MCLR and spreads charged over them” and “undermining the integrity of the interest rate setting process.”

Bankers’ angst over MCLR is neither surprising nor misplaced. MCLR is a theoretical construct that is completely divorced from the ground realities of banking in India. Critics would even describe it as a desperate bid by RBI to somehow compel banks to pay heed to its policy signals. In fact, in many ways, it is a throwback to the bad old days of directed lending!

Under directed lending, banks did as they were directed by RBI; no questions asked. Needless to say, it was highly inefficient, as it was unrelated to market forces of demand and supply. The shift to a market-driven regime was meant to change all this. Banks were free to determine interest rates, both on deposits (with the exception of savings bank deposits on which interest rates were freed much later) and on loans, based on market forces of demand and supply.

However, in a bid to ensure transparency and better transmission of its signals, banks were directed by RBI to announce a ‘prime rate’ (the rate applicable to the best or prime borrower). Subsequently, in response to complaints of lack of transparency, the ‘prime rate’ was replaced by the ‘base rate’, which was to be determined by a formula specified by RBI.

The shift from the prime rate to the base rate, however, did little to improve monetary transmission—the process by which RBI’s rate signals are acted upon by banks. As a result, RBI was constantly criticised that its monetary policy actions were not particularly effective. Bank lending rates did not move in tandem with policy rates. Not only was there no one-to-one relationship between increases/decreases in RBI’s policy rates and banks’ lending rates, there were also occasions when bank lending rates did not budge in response to RBI’s signals. It was alleged that while banks were quick to hike their lending rates in response to a hike by RBI, they were less willing to reduce rates when the central bank cut rates—an allegation denied by banks.

In an attempt to remedy this situation, in April 2016, under former Governor, Raghuram Rajan, RBI again intervened. This time, it directed banks to shift from the base rate to the Marginal Cost of Lending Rate (MCLR) system, under which the weighted average cost of deposits was replaced by the marginal cost of funds. Bankers tried to reason with RBI, but the central bank would have none of it! And so, much against their will, they shifted to the new regime in April 2016.

Now, close to 18 months after the MCLR regime has been in operation, we are back to square one, with RBI once again berating banks for not transmitting its policy signals. How valid is RBI’s criticism? Consider, for instance, floating rate loans. The rate of interest on floating rate loans is a mark-up over a reference rate. So, when RBI lowers the policy rate, if banks respond to it in like manner, all loans with floating rates would have to be marked down. This might be fine for new loans, but lowering the rate of interest on old loans funded by costlier deposits results in a huge loss.

Moreover, all deposits in India are contracted at a fixed rate. However, a substantial (and increasing) part of the loan portfolio is on a floating rate basis. Consequently, banks are unable to adjust the cost of their deposits in line with changes in interest rates on the lending side. In a falling interest rate regime, a decline in lending rates that cannot be translated into a fall in deposit rates till such time as deposits that were contracted earlier mature puts additional pressure on bank margins. Inevitably, under an MCLR regime, banks will tend to avoid long-term deposits, where interest rates are fixed for a longer period of time, increasing their ALM (asset-liability management) problems.

Remember, RBI’s money market operations are all at the short-end, typically through overnight and short-term repos/reverse repos. So, its policy rates can, at best, affect the short-term money market. Moreover, RBI does not lend an unlimited amount to banks. A fundamental principle of market-pricing is that any player that wants to influence the price should be willing to either sell or buy unlimited quantity at that price. In fact, RBI is supposed to be the lender of last resort, which means RBI comes into the picture only when banks have liquidity problems.

Competition, rather than diktat, is the way forward in a market-driven economy. RBI, sadly, does not seem to believe in market forces.

NR Bhusnurmath, Professor of Finance and Banking, MDI Gurgaon.

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