Government bond yields have been rising despite yet another policy rate cut by the Reserve Bank of India (RBI). The banking community, too, is not very enthusiastic about taking the cue from RBI and cutting loan rates. And the central bank has probably reached a stage from where it will find it extremely difficult to lower rates further.
Have interest rates bottomed out? Is there any way to push bankers to lend to companies at cheap rates? Can they be enticed to buy government paper—key to the success of the government’s massive borrowing programme in the next fiscal year?
All these are possible if RBI can cut its policy rates further. Experts have been suggesting deep rate cuts, by as much as a full one percentage point, to prop up sagging economic growth.
Also Read Tamal Bandyopadhyay’s earlier columns
Can RBI do this? Can it be even more bold and bring down the policy rate to zero? Yes, it can, through the back door.
Let’s listen to an imaginary conversation between a banker and a borrower to understand the predicament of different entities in the Indian financial system and how RBI can actually cut its policy rate to zero.
Edited excerpts of the dialogue:
Borrower: RBI has cut both its repo and reverse repo rate by half a percentage point each to 5% and 3.5%, respectively, but why aren’t you still cutting your loan rates?
Banker: We can’t bring down our loan rates because we are not able to bring down our deposit rates.
Borrower: Why can’t you bring down your deposit rates?
Banker: Well, we have brought the rates down from around 9.5% to 8% for one-year deposits, but we won’t be able to bring it down further as the government pays 8% on various small savings plans, offered by post offices. So, if we pay less than 8% to our depositors, they will stop coming to banks and park their savings in post office schemes.
There is yet another hurdle. Our depositors are required to pay income tax on their earnings. In fact, we deduct tax at source while paying interest on deposits. This is not the case with small savings schemes. So, the earnings on bank deposits are lower than what the government’s small saving schemes offer. We cannot bring down the rates further unless the government brings down the small savings rates.
Borrower: Since you are lending to good customers at below your prime rates, what prevents you from bringing down your prime lending rates?
Banker: Again, there is a structural issue. There are quite a few mandated loan rates. For instance, we need to offer loans to exporters at two percentage points below our prime rates. Similarly, farmers and other borrowers too must get loans at below prime rates. Overall, such loans account for about 30% of our total loan book.
So, if we bring down our prime rate, automatically earnings on such mandated loans will go down. But if we do not bring down our prime rate, we won’t need to compromise on our earnings from such loans. At the same time, we have the flexibility of offering loans at below prime rates to the good customers.
Borrower: I see… Again, a structural issue. But why are the bond yields going up despite the rate cut?
Banker: This is because of over-supply of bonds. The government is flooding the market with bonds but banks don’t have the appetite for such a large government borrowing programme. Naturally, the prices will go down and yields will go up.
The situation will get worse next year. The central bank has been trying hard to maintain stability in the market. It is, in fact, buying bonds but unless the government starts privately placing bonds with the regulator, the sentiment won’t improve.
Borrower: What prevents the government from privately placing bonds with the regulator?
Banker: Private placement of bonds with the central bank amounts to monetization of fiscal deficit. Under the Fiscal Responsibility and Budget Management (FRBM) Act, monetization is not allowed unless the government admits that there is a crisis. It also needs the nod of Parliament. Probably this will happen after a new government takes over in June.
Once RBI starts printing money, the pressure on the bond market will ease but we will run the risk of fuelling inflation. But I guess when inflation is dramatically coming down, this is an ideal solution.
Borrower: Can RBI do anything else to bring down the rates? Say, cutting down the policy rate further?
Banker: It’s difficult. It has brought down its repo rate ,or the rate at which it infuses liquidity in the system, to 5%. And the reverse repo rate, or the rate at which it sucks out liquidity, is now 3.5%. Since the mandated savings bank rate is 3.5%, RBI will not be able to bring down its reverse repo rate further as it cannot have a policy rate lower than the rate banks offer on savings deposits. In that sense, a 3.5% policy rate in India is equivalent to zero in the US. Unless the savings rate is brought down, RBI will not be able to cut its reverse repo rate.
Borrower: Can the savings bank rate be brought down?
Banker: It’s highly unlikely at this point. It’s a political issue as millions of depositors are involved. RBI cannot go ahead on this without the government’s nod. It can happen when a new government takes over after the elections.
Borrower: Does this mean there won’t be any more rate cut?
Banker: I am not saying so. RBI can cut its repo rate and bridge the gap between repo and reverse repo rates, which is one and a half percentage points now.
Borrower: Will that help?
Banker: Hardly. Theoretically, the rate in the overnight call money market— from where banks borrow to tide over temporary asset-liability mismatches— should move in the corridor between repo and reverse repo rates. If the corridor shrinks, the volatility in the overnight call money rates will diminish. But with plenty of liquidity in the system, call money is moving at the lower end of the corridor and there is no volatility.
Borrower: Experts have been suggesting that RBI should bring down its policy rates further to bolster the slowing economy. What should the central bank do now?
Banker: It can bring down the policy rate to zero.
Borrower: Just now you said the policy rate cannot go down below 3.5%.
Banker: RBI can reduce it to zero through the back door.
Banker: It should stop sucking money out through its reverse repo window.
Borrower: Can’t follow it. Will you please explain?
Banker: As you know, unlike other central banks, RBI has two policy rates— repo and reverse repo. In a liquidity-starved situation, repo is the policy rate, as RBI infuses money at this rate. And, in a liquidity-surplus situation, as is the case now, reverse repo is the policy rate. Is this clear?
Borrower: Yes. Go on.
Banker: All RBI needs to do is stop taking money out of the system. If RBI does not accept money at its reverse repo window, the 3.5% rate becomes irrelevant.
Borrower: Can’t follow you.
Banker: It’s simple, my dear. Banks have enough money in their coffers and every day they park this money at RBI’s reverse repo window where they earn 3.5%. RBI opens the window twice a day. On Friday, for instance, the banking system put Rs35,250 crore in the morning and again Rs31,530 crore in the afternoon, taking the amount for the day to Rs66,780 crore. In the past two weeks, on an average, banks have been keeping Rs64,763 crore daily with RBI, earning 3.5%.
Borrower: So what?
Banker: They are not giving loans or buying bonds as they are earning at least 3.5% on their surplus funds. If RBI stops taking their money, they will be left with no choice but to look for borrowers and invest in government bonds as money has a holding cost and if they do not earn anything on idle money, their income will go down.
Borrower: Are you saying that liquidity will start chasing assets?
Banker: Exactly. The moment we know that RBI will not allow us to park money with it, we will be forced to deploy the money elsewhere.
Borrower: But can RBI do this?
Banker: Why not? It can simply put a cap on how much money a bank can keep with RBI. For instance, it can fix the limit at 1% of total deposits. Right now, the banking system has a deposit base of Rs36.8 trillion. This means that at 1%, banks can keep up to Rs36,800 crore with RBI, much less than what they have been doing now. The actual amount will be much less as all banks do not have surplus liquidity.
Borrower: So even by keeping the 3.5% rate unchanged, RBI can effectively bring down the policy rate to zero?
Banker: Yes. If I have surplus money and RBI is not taking it, I will be forced to use the money and earn something. I will bring down my loan rates and also buy bonds as something is better than nothing. A lazy banker will become a busy banker.
Borrower: Why don’t you suggest this to Governor D. Subbarao at your next meeting?
Banker: Are you crazy? I should not have discussed this at all.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Comments are welcome at firstname.lastname@example.org