The efficiency of monetary policy, as a rule, gets enhanced if there is a surprise element. If everyone expects the expected, then the impact is less distinct as the market has buffered in the same. The monetary policy announced on September 29 took the market by surprise with a bold and aggressive reduction in interest rate by 50 bps. This step can be called bold because we are assuming a certain inflation path to fructify while it is aggressive as the rate cut is of a higher order and a deviation from the 25 bps approach pursued so far.
Interestingly, if one goes back to the August statement, the rationale provided for not lowering rates holds even today. Inflation, though down, is expected to increase given that the ministry of agriculture has projected lower kharif production this season. Thus, ‘inflationary expectations’, which were the crux of the August argument, actually remain high. But as RBI is still looking at a number of close to 6% by January 2016, it was reasonable to assume that we are on the right path. The uncertainty regarding the Fed interest rate hike remains today with the added worry of funds moving out once lower rates in India are juxtaposed with higher rates overseas. FPI investments have been negative in the last two months. Yet RBI has decided to toss for growth and lowered rates. This should assuage industry, which has made it a habit of asking for interest rate cuts every time there is a policy. But will it work?
Let us look at the position of banks in terms of extreme cases. Deposits were around Rs 90 lakh crore as of September, of which Rs 82 lakh crore were time deposits. Assuming growth of, say, 15% from here on, incremental deposits would be Rs 12.3 lakh crore. Every 25 bps reduction in interest rates would benefit the system as a whole by Rs 3,075 crore as outstanding deposits would be on contracted rates and not be subjected to new lower interest rates.
Outstanding credit was Rs 67 lakh crore and assuming 10% growth in credit, the amount would be Rs 6.7 lakh crore. On the lending side, virtually 90% of loans get repriced almost immediately. So, of the total credit of, say, Rs 73.7 lakh crore, 25 bps reduction in rates would be a decline in interest income by Rs 16,580 crore. Hence, if both deposit rates and lending rates are lowered to the same extent at the same point of time, then there would be a loss suffered by banks. This is the conundrum of the ‘impossibility of proportionate transmission’ across banking business.
This is one reason why banks are quick to lower deposit rates, which will lower the cost for them immediately, while the lending portfolio would react with a lag by a smaller magnitude. In fact, to attain a closer to equilibrium net gain, banks would have to lower deposit rates by 125 bps to match the loss on loans on account of 25 bps reduction in rates (see table 1).
While one may complain about the transmission mechanism being tardy, the numbers presented show the practical difficulty in doing so. Add to this the high NPAs that banks have and the interest rate spreads tend to be very high relative to those in other economies.
With RBI and the government deciding that banks would be convinced to lower interest rates, which some have already done, the next question is whether this will really help in reviving investment in the economy. Would bank credit pick up merely because interest rates are lowered?
This is important because the ultimate goal of lower interest rates is to make borrowing cheaper. Ironically, on the day of the monetary policy, the RBI report on capacity utilisation shows that the average for industry had actually come down in Q1 of FY16 to 71.5%. This certainly does not indicate that industry will be in a rush to invest, unless there is a turnaround in demand conditions. Even in the past, lowering of interest rates has not always resulted in a higher offtake in credit.
Table 2 juxtaposes growth in bank credit with the repo rate for the last five years. There is evidently no clear pattern in the movement in repo rate and growth in credit over the years. The highest growth rate in credit was witnessed in 2010-11 when the repo rate was increased by 175 bps.
How then can this rate cut be interpreted? First, the aggression in the quantum could be interpreted as compensation for a partial decrease in retrospect for August when similar economic conditions and concerns made RBI think otherwise. Therefore, in effect, it is a case of 225 bps reduction in the rate. Second, as it has been overtly stated that the government will speak to the banks and have them lower their rates, one could expect the same. We could expect between 25-50 bps cut in base rates going ahead. Third, while rates will be cut and there could be some uptick in growth in credit in the third and fourth quarters, the impact on growth would be muted in FY16, which is also supported by the fact that RBI has toned down its forecast for GDP growth, albeit marginally from 7.6% to 7.4%, without mentioning any positive growth stimulus. Fourth, as a corollary, RBI has prepared the setting for the next investment cycle by working towards bringing down interest rates when companies actually borrow.
Last, as table 2 shows, interest rate has an important but not a decisive role to play in investment decisions as no one invests just because rates are low. Demand conditions, infra bottlenecks, supply of raw material, land and environment issues also influence such decisions. Therefore, we must be abstemious in terms of expectations on final outcomes.
The author is chief economist, CARE Ratings. Views are personal