The repo rate cut cycles help PSBs shore up capital

What does Acharya say in his book?

Viral Acharya writes in Quest for Restoring Financial Stability in India: “Rate cuts are preferred … whereas rate hikes are particularly disliked." Now, this is primarily because the government is a major owner of the public sector banks (PSBs). These banks, in particular, have been in a mess for the last 10 years. As a result, they have accumulated a huge amount of bad loans, or loans that have not been repaid for 90 days or more.

Due to loan defaults, the government, as the owner of these banks, needs to constantly recapitalize them or keep investing more money in them, to keep them going.

What is the problem with repo rate cuts?

The government is trying “to keep the budgetary allocation for public sector banks’ capital needs low". Repo rate cuts help in doing that. When the repo rate is cut, the value of the government bonds held by the state-owned banks goes up. This is because when interest rates go down, bond prices go up and vice versa. When bond prices go up, the PSBs end up making profits. This profit is recognized almost immediately, and helps shore up the capital base of these state-led lenders. Also, the government does not have to dip into its budgetary revenues to shore up the capital of public sector lenders.

What else does Acharya say about central bank’s role?

“The central bank is often working the hardest to ensure that public sector banks can show profits and adequate capital to markets," he writes. Hence, repo rate cuts are not just about signalling banks to cut their deposit and lending rates, they are also a way of pushing up bond prices and help shore up the capital base of state-owned lenders.

What about when the repo rate goes up?

When the repo rate goes up, PSBs make losses on their bond investments. However, these losses, which are referred to as treasury losses are not recognized immediately. “Treasury gains [profits made when bond prices go up] are transferred for the most part as soon as bond prices rally. In striking contrast, treasury losses are allowed to be recognized over several quarters," writes the former RBI deputy governor. This is bad policy as it is influenced by the government’s need to keep shoring up the capital of PSBs.

What is the cost of cutting repo rates?

Slashing rates often leads to a situation where the repo rate is lower than the prevailing rate of inflation, as is the case at present. In June 2020, inflation, as measured by the consumer price index had stood at 6.1%. On the contrary, the repo rate is at 4%. The fixed deposit interest rates offered by most banks are between 5% and 6%. This means that people are basically losing money by investing in fixed deposits, once it is adjusted for inflation.

Vivek Kaul is the author of Bad Money.