Last-mile transmission a big hurdle to policy rate cut

The MPC of RBI raised the repo rate by 250 basis points between May 2022 and February 2023. It has since kept the key policy rate unchanged. (Photo: Mint)
The MPC of RBI raised the repo rate by 250 basis points between May 2022 and February 2023. It has since kept the key policy rate unchanged. (Photo: Mint)


  • Previous repo rate hikes yet to fully impact lending rates; deposits too lag central bank actions

Mumbai: What’s holding back India’s central bank from cutting policy rates? Apart from the pace of price rise that is yet to align with Reserve Bank of India’s (RBI) target of 4%, there is another factor at play — transmission of past repo rate actions into lending rates.

The monetary policy committee (MPC) of RBI raised the repo rate by 250 basis points (bps) between May 2022 and February 2023. It has since kept the key policy rate unchanged, looking for ‘durable’ signs of disinflation and a fuller transmission of rates.

However, between the start of the tightening cycle in May 2022 and till February 2024, the weighted average lending rate on fresh loans by banks increased by 185 basis points (bps), showed data in RBI’s half-yearly monetary policy report released last week.

The last mile of transmission, akin to the last mile of disinflation, seems to be the hardest for lenders as over 40% of system credit is not linked to the repo rate. Although loans linked to external benchmarks — mostly the repo rate — have been repriced, those linked to the marginal cost of funds-based lending rate (MCLR), an internal benchmark, are lagging the rate hikes. While the external benchmark rate would change as the repo rate moves, the MCLR depends on the cost of deposits.

To be sure, retail and small business loans are linked to external benchmarks, and corporate loans are still on the MCLR. The external benchmark rate has moved in tandem with the repo, but the median one-year MCLR has lagged and gone up 155 bps between May 2022 and March 2024.

“Today, we have a situation where banks have selectively increased deposit rates because there is a lot of uncertainty on when the cycle will turn," said Madan Sabnavis, chief economist, Bank of Baroda.

According to Sabnavis, banks have been only increasing the short-term rates or those of up to two years as they do not want to be in a situation where deposits are locked in for five years, but the rates decline in the coming months. “Since there is no uniformity in how deposit rates have gone up, MCLR increase will also be gradual," said Sabnavis.

Experts said RBI believes that if it wants to make the repo rate a meaningful monetary policy tool, it has to ensure that interest rates go up when the key rate moves up. In theory, if the repo rate goes up, all lending rates go up, cost of credit goes up, and that should ideally affect demand and curb inflation.

Saugata Bhattacharya, an independent economist, said that despite liquidity conditions having remained tight in late 2023, banks do not seem to have passed on the higher cost of funds to borrowers whose loans are linked to MCLR.

“One reason could be a concern regarding losing these loan accounts to competitors and, hence, loss of market share. Pricing of MCLR interest is more complex than EBLR, involving deposit mix, margins, etc., and so there is more leeway in transmission," said Bhattacharya. EBLR refers to external benchmark-based lending rate, which, as the name suggests, is linked to benchmarks like the RBI repo rate and is used to price loans.

The central bank recently asserted that transmission is in progress and its effort is to ensure fuller transmission of policy actions and anchoring of household inflation expectations. “So, we are still seeing a little bit of transmission going through and we feel that as the mobilizing of deposits takes place at higher and higher rates, there will be further transmission to lending rates," RBI deputy governor Michael Patra told reporters at the post-policy press conference on 5 April.

Bankers said that it takes at least nine months for deposits to reprice once the old ones mature and fresh funds come in at the new rate. As per RBI data, the weighted average term deposit rate on fresh and existing deposits increased by 241 bps and 183 bps, respectively, between May 2022 and February 2024.

Bhattacharya said that RBI’s concerns on incomplete transmission, while understandable in the context of the current rate cycle, is a little puzzling, but is probably related to bullish financial and credit conditions. “If correct, these concerns should largely be about unsecured retail loans driving up equity markets, directly or indirectly," he said, adding that yet, these are EBLR loans, where full transmission has happened.


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