A forward-looking policy paradigm

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Published: April 8, 2015 12:16:48 AM

With the central bank inflation guidance suggesting a sombre trend between now and August, front-loading a repo rate cut remains an option

The Reserve Bank of India’s decision to hold rates (repo and CRR) was as per market expectations. With liquidity in abundance, the central bank is now convinced that the rate easing cycle is round the corner. Interestingly, the Patel Committee Report had stated that “in times of liquidity abundance, the interest rate channel is diluted and there are asymmetric responses to liquidity conditions with medium- to long-term rates such as bank deposit and lending rates responding faster with relatively larger responses in liquidity deficit than in surplus conditions.”

Against this backdrop, the million-dollar question is, when will the bank start cutting rates? RBI has already indicated that it is going to nudge banks to use marginal cost of deposits as an input in base rate estimation. However, as per standard microeconomic theory, aka 101, in a situation of declining (increasing) interest rates, marginal cost of deposits will always be higher (lower) than the weighted average cost of deposits. This will mean banks charging less (more) under declining (increasing) interest rate regimes. While it may seem logical in terms of theoretical underpinnings, the crucial issue will be the seasonality in marginal deposit accretion resulting in loan pricing becoming significantly volatile.

Elsewhere, the policy makes a pragmatic attempt to shift bank borrowing in India towards market funding in an effort to rectify the asset liability pricing mismatch. Therefore, the policy talks about making retail participation in treasury bill auction through non-competitive bids.

Given that there is a clear spread between bank short-term deposit rates and such rates (around 150 basis points) and such deposits offering tax advantages vis-a-vis bank deposits, it may be logical to assume that bank deposits migrate towards better market-determined rates. While such an idea is noble and pragmatic, in a country like India where social security is not guaranteed, it may be a long transition.

Interestingly, in developed regions such as the US and Europe, market funding of banks in the form of collateralised term funding, derivatives and interbank funding has been replaced by a combination of central bank funding and, in some cases, customer deposits post-2008. The overall share of customer funding in total liabilities started to increase, marking a broad shift relative to the pre-crisis period when it had declined. For example, since 2008, the share of deposit funding for the banking system in the US as a whole has risen sharply more than 70% of total liabilities at end-2014 (67% in 2008).

There are several other excellent initiatives in the policy also. The G-Sec market in India is predominantly institutional in nature. To increase participation of the retail investors in the G-Sec market, RBI has proposed a web-based solution on the eKuber platform for retail investors having gilt accounts. In order to tap private savings through G-Secs, retail investors will be provided direct access to both primary and secondary market platforms without any intermediary.

Allowing the issue of rupee bonds will facilitate internationalisation of domestic currency. Allowing cooperative banks to issue credit cards and setting up ATMs is a step in the right direction in enabling a seamless access to bank finance. The move to allow NBFC-IDFs to provide takeout finance for infrastructure projects that have completed one year of operation in the PPP segment without a tripartite agreement and to the non-PPP segment is a welcome move and may help meet the financing requirements of the infrastructure sector.

I would like to end on a positive note. Notwithstanding the base effect, with the central bank inflation guidance suggesting a sombre trend between now and August, front-loading a repo rate cut still remains an option (we are foreseeing a lower inflation rate compared to the central bank’s 5.8% projection). Additionally, we believe the Fed rate cut may be delayed even beyond September, as historical trends suggest that Fed hikes rates (with a two-month lead) only when inflationary expectations get a leg-up. With such expectation currently at around 1.2%, an imminent Fed rate hike looks difficult. From that point of view, RBI may get enough window to cut rates even if it does not believe in front-loading. Also, with credit demand picking up pace (both funded and non-funded) for coal and telecommunication companies (the next round of coal auctions are due from April-end till mid-June), we may still have a lending rate transmission round the corner! In fact, as we go to the press, SBI had already cut its lending rate by 15 basis points. Let’s hope for the best.

The author is chief economic advisor, State Bank of India. Views are personal

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