Column: For a better interest rate transmission

By: and | Published: August 5, 2015 12:24 AM

Allowing greater banking competition could contribute to strengthening the transmission channel indirectly

The strength of a central bank’s monetary policy and its impact on the real economy depends to a great extent on the effectiveness of the so-called monetary policy transmission, which broadly refers to the process by which monetary policy changes are transmitted to the real economy. The four common channels through which monetary transmission occurs are interest rates, exchange rates, asset prices and the credit channel—with the credit channel further broken down into the bank lending channel and the balance sheet channel. While these channels are important for a smooth functioning of monetary transmission, in emerging markets like India the interest rate and bank lending channels assume greater significance. The interest rate channel should matter even more given India’s move to an inflation-targeting regime.

Many academic studies have pointed out that the interest-rate pass-through (IRPT) in India is incomplete and needs to be fixed for monetary policy actions to produce the intended effects on the real economy. The disconnect in the monetary policy transmission was evident even in the most recent rate cut episode by RBI. To be sure, in its monetary policy review in June, RBI implemented another round of repo rate cuts by 25 basis points, over and above the cumulative repo rate cuts of 75 basis points since January. But those changes have not been passed on by banks to lending and deposit rates yet. This lagging response from banks in passing on RBI’s rate changes is a source of concern for policy-makers. For instance, finance minister Arun Jaitley had to meet public sector banks to emphasise the need for them to pass on policy rate changes of RBI to lending rates. While this may or may not have convinced banks to pass on policy rate cuts to lending rates, the larger question that remains is, whether there is a more efficient way to enhance interest rate transmission?

Theory tells us there are two ways through which IRPT can happen. The first occurs in two stages through cost of funds, wherein changes in policy rates are transmitted to interbank rates in the first stage. In the second stage, changes in inter-bank rates are transmitted to other yields of higher maturity through arbitrage and then to deposit and lending rates. The key for the second stage of transmission to work is the existence of a well-developed yield curve by which changes in short-term rates are passed on to long-term rates.

But does this two-stage pass-through always work? In countries like India that have relatively underdeveloped financial and bond markets and the yield curve is not fully developed, the IRPT occurs directly through “moral suasion” where central banks will be able to prevail upon other banks to pass on changes in policy rates to lending and deposit rates.

Research points out that one of the important ways by which a country can achieve IRPT is through financial sector development, which enables smooth functioning of bond markets—a prerequisite for the existence of a stable yield curve. There is evidence to suggest that allowing greater banking competition (by promoting private domestic or foreign banks) could contribute to strengthening the transmission channel indirectly through its impact on financial market development.

While competition can be enhanced through private domestic banks, foreign banks contribute to the enhanced functioning of the money market in addition to transferring technology and best practices, which are likely to strengthen the pass-through. While India has been slow compared to other emerging markets in liberalising its banking system, it has been loosening its grip over domestic banking system. The share of domestic and foreign private banks in the total banking assets in the country has tripled over the last three decades, to about 30% in 2015.

This gradually changing financial structure leaves India with an interesting predicament that could help understand the reasons behind the weakening IRPT of late. On one hand, India’s gradual but insufficient liberalisation of its banking system has meant that the pace of such liberalisation has not been adequate to contribute to overall financial market development. On the other hand, the process of gradual liberalisation has also implied a slow but sustained reduction in the power of moral suasion by the central bank to influence the IRPT. A combination of these factors could continue to result in a weak and incomplete transmission process until more robust policies encouraging greater banking competition and financial sector development are in place.

While banking competition and bond market development could go a long way in addressing the transmission problem without having to think about ways to compel banks to pass on the interest rate changes of RBI, an important caveat is worth noting. If a liberalisation process results in a banking system dominated by a few large private banking players—as in the case of some Central and Eastern European countries—that could be antithetical to the spirit of competition. Higher levels of concentration merely imply a transfer of ownership from a government-dominated system to a market structure dominated by a few private domestic or foreign banks. This may well result in a weak IRPT as private banks might refrain from passing on policy rate changes to lending and deposit rates, and the central bank or the government unable to use moral suasion to force private banks to pass-through interest rate changes.

Rajan is a visiting professor at the Lee Kwan Yew School of Public Policy, National University of Singapore. Gopalan is a post-doctoral fellow at the Institute for Emerging Market Studies and Institute for Advanced Study at the Hong Kong University of Science & Tech

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