During my years as an analyst for financial services, the following discussion with foreign investors was quite common:
“What is your assumption on by how much RBI will reduce (or increase) rates in the next 12 months?”
“100 basis points” (say).
“Have you factored that into your bank earnings models?”
The conversation used to stop here or take a different turn. The investor invariably felt that I was not to be taken seriously.
What saved me many years later was RBI’s popularization of the phrase “insufficient monetary transmission”. In plain language it means interest rates in India have a mind of their own, and do not bother to follow the signals given by RBI through their policy rate changes.
This does not mean financial sector participants are pathologically prone to insubordination. There are such a large number of distortions in the system that synchronized interest rate behaviour is simply not possible. And many of these distortions are imposed by the regulator and government themselves, including direct controls on some interest rates. It is churlish to expect banks to precisely follow RBI policy rate movements after imposing these controls.
This issue has acquired emotional contours. There are repeated complaints from the government and industry that banks do not adequately “pass on” RBI rate reductions to borrowers, but apparently are very timely about rate increases (“downward rigidity of interest rates”). Matters get worse when banks reduce home loan rates for new borrowers but not for the existing ones. Very few, least of all the government, appreciate that that policy rates are a signal and not a command.
But weak transmission leads to decrease in effectiveness of monetary policy and needs to be constructively improved. This includes, but not limited to, a gradual reduction in distortions, like rate controls on small savings deposits, reserve appropriation of banks and increase levels of lender competition. The imperfections and obstacles are so many that we cannot list all of them here.
Admittedly, a lot of good work has been done in these areas. Appropriation has been reduced, small savings rates have been made market-linked and banking has been made stunningly competitive. But a lot more needs to be accomplished. For example, statutory appropriation is still 24%, the highest in the world, keeping the government bond yield artificially low. RBI has made half a dozen attempts in the last 15 years to persuade banks to set a benchmark lending rate, but ingenious banks and borrowers have been subverting them regularly.
While I don’t hold a brief for any bank, it is important for us to dispassionately appreciate a few issues; else we will always bark up the wrong tree. “Not passing on” RBI policy rate changes is not with an intention to keep spreads high but due to loans and deposits rolling over at widely different points in time (“asset-liability mismatch”). Also, monetary policy signaling typically happens with the help of a short-term rate like repo rate, whereas loans, investments and deposits are (relatively) longer-term.
I do not have a grouse against the systemic distortions mentioned earlier because many of these are a result of policy decisions that have their own merits. So fulminating against banks, holding them solely responsible for transmission inadequacies just does not help and perpetuates the weakness.
Many times this takes the form of direct interference. In January 2008, RBI continued to signal tightening. In February 2008, the finance ministry “requested” PSU banks to lower their lending rates because “high” rates were impeding growth (impeding growth? In Feb 2008???). They cut their prime lending rates by 25 basis points. Not happy with that, the finance ministry “requested” more, so they followed up with another 25 basis points cut. All this in a tightening environment - an example of reverse (manual) transmission.
The finance ministry is again making the dangerous mistake of sending feelers to banks that lending rates should go down, apparently because “inflation has peaked”, when funding costs are still on the rise. It is dangerous because after the sordid Coal India episode, any public sector company will consider a directive to accommodate as tantamount to crawl. Banks that have selectively reduced lending rates even on small products like education loans have sent the wrong signals.
Nowhere in the world is monetary transmission perfect. For the US, increase in transmission was essentially a post-Volcker era phenomenon. Euro area transmission levels are still unsatisfactory. Among emerging economies, no one scores particularly better than India. But policymakers have to work towards ensuring that transmission does not remain in Brownian motion.
As for now, rates will continue to have a mind of their own. So do not try to draw a straightforward correlation between what RBI does to policy rates and at what rates you borrow or deposit money.