With the repo rate becoming progressively less potent as a tool to influence lending rates, alternative measures have been used to bring down rates through market forces.
The architecture of monetary policy has changed over the years, where central banks go beyond the reference rate to influence the monetary situation. It started with the quantitative easing (QE) process, which involved large-scale purchase of private bonds such as mortgage-backed securities (MBS) and asset-backed securities (ABS) by the Federal Reserve to provide liquidity to the market. This was when the interest rate was lowered to the extent that it ceased to matter, as banks were not willing to lend to one another following the Lehman crisis due to issues of trust. This was reminiscent of the Keynesian liquidity trap where the supply of money became flat and the only way to improve the situation was to move the money supply curve upwards through QE.
The Reserve Bank of India (RBI) has been at the same job for quite some time now, where it has worked hard to bring interest rates down to lower the cost of funds for industry. While the repo rate was the tool used to begin with, there has been a gradual move over to other systems to influence both liquidity and interest rates. Let us see how this situation has evolved, of late.
The first option is the conventional repo rate, which is the benchmark that has been used to lower the cost of funds for banks, which then feeds into the base rate that is used by banks when calculating their benchmarks. When this did not work, given that not more than 1% of NDTL (net demand and time liabilities) was available at this rate—which was quite small in quantitative terms to influence the base rate—the concept of MCLR (marginal cost of funds based lending rate) came in, where the marginal cost was reckoned. Yet the transmission was sluggish.
Second, in FY19, RBI induced a record Rs 3 lakh crore in the form of OMOs (open market operations), where it bought government securities from banks. In a way, this is what QE was all about where liquidity is provided by the central bank to lower yields in the market. The difference is that QE also deals with private bonds that were large in quantum, while OMOs pertain to G-Secs (government securities) only. Hence, liquidity infusion has been another move used quite aggressively by RBI to ensure that yields soften and funds are available to the market.
Third, RBI went in for the purchase of dollars from banks so that liquidity is provided to them. This was done in 2019 where a sum of $10 billion was purchased by RBI in two tranches. This was a rather innovative measure brought in to enhance liquidity at a time when bank deposits were not increasing at the desired pace. A sum of Rs 70,000 crore was hence made available through this route. However, there are limitations to the extent to which this can be used as it depends on the quantum of forex with commercial banks. As long as forex comes in, banks would be able to sell the same to RBI under such operations.
Fourth, since December 2019, RBI had gone in for what informally was called ‘operation twist’, which was one where central banks bought and sold an equal quantum of G-Secs but of varying tenures to ensure that liquidity was not affected but yields were guided in the desired direction. The focus was on buying 10-year paper, which pushed up demand and hence price, which, in turn, brought down yields on this tenure. At the same time, by selling securities of a shorter duration of 1-year, yields went up and hence there was a narrowing of the yield gap between the longer and shorter ends of the maturity spectrum. A sum of Rs 40,000 crore was swapped so far. While bank lending rates do not get touched by this move, market rates tend to move in sync and the corporate bond spreads, which can vary between 70 bps and 450 bps depending on the rating of the debt paper, move in accordance with the new yield curve.
Fifth, RBI has introduced the concept of linking specific loans like SME and retail to pre-announced benchmarks. This is significant because as banks fix these benchmarks, any change in these indicators due to monetary policy would lead automatically to transmission to loans, which use these as anchors. Hence, if loans are linked to a treasury bill yield or repo rate, the changes in the latter will get reflected automatically here. This measure will work as long as the market-based benchmark changes. However, if linked with the repo rate, then the impact would be restricted to the extent to which RBI lowers this rate. One can think of such norms being introduced for other segments too, which ensure that the transmission of policy is swifter.
Sixth, more recently, RBI has announced that it would no longer have a fixed repo rate auction on a daily basis, and would move over to targeting the weighted average call rate. This automatically makes the market more vibrant as the call rate will drive yields more than the repo rate. Hence, while repo and reverse repo rates would still be fixed at auctions, the market will be looking at the call rate to take clues. Yields on G-Secs would also be guided indirectly by what happens to short-term liquidity in this market.
Seventh, the LTRO (long-term repo operation) is a novel concept where banks can borrow money at a fixed rate for a longer period of time. While judgement on future rate movements will be important here, there will be a tendency for the 1-year and 3-year papers to also get aligned to these term repos that would be prevalent in the market. This is a unique way of providing funds to banks, while also influencing G-Sec yields as when banks bid in these auctions the price will tend to equalise with the corresponding 3-year security. However, there would be anomalies in case rates start moving up and the 3-year G-Sec trades at a higher rate than the 3-year term repo issue.
Last, the concept of having exemption of CRR (cash reserve ratio) for incremental loans to SMEs and retail for a fixed time period is another novel measure used by RBI to enhance the flow of funds to these sectors, while also simultaneously bringing down the cost of funds that will get reflected in the base rate/MCLR as the cost of CRR comes down. Intuitively, one can see this mode being used for sector-specific loans too, and while the overall level of CRR is not touched, the exemptions will afford additional space.
Hence, RBI has brought in a lot of innovation when conducting monetary policy so that it is better able to guide the quantum of liquidity in the system as well as manage the same across sectors. With the repo rate becoming progressively less potent as a tool to influence lending rates, alternative measures have been used to bring down rates through market forces. One can expect more such steps being taken by RBI that make monetary policy more effective.
The author is chief economist, CARE Ratings. Views are personal