Going into the monetary policy announcement of 6 June, with the growth slowdown confirmed, and tame inflation readings, it did not seem to be an issue so much of whether but by how much the repo rate was going to be reduced. The 25 basis points reduction which actually happened was at the soft end of the very wide range of expected cuts.

For this policy, and all bi-monthly policies to come, the continuing concern is going to be effective monetary transmission. How much will any reduction in the policy repo rate translate into actual lending rate reductions on the ground? And then, there is the further issue of the extent to which cheaper borrowing rates prompt enhanced private investment activity— the ultimate real outcome targeted.

The repo is an overnight rate. The problem is that the term premium, the difference between the market yield on 10-year government securities (GSecs) and the overnight repo rate, is currently at high levels compared to the past. Since private borrowing for investment will not be at the overnight rate, nothing may happen to lending rates if a drop in the repo rate is accompanied by a rise in the term premium. And then there is also the credit spread, which even for triple-A rated borrowers will be above the (zero-risk) GSec rate.

So that is the monetary transmission problem. Why is the yield on GSecs reigning so high? There are respected analysts who see the high term premium as a result of alarmist noises made by the Monetary Policy Committee (MPC) about the future trajectory of inflation. If that is so, the term premium could actually be talked down by the MPC by issuing soothing messages on future inflation. But is the market so heavily influenced by the inflation projections of the MPC?

Transmission of a repo rate reduction to lending rates requires at the first stage transmission to bank deposit rates. Banks compete for deposits with small savings schemes (SSS). These SSS deposit rates are benchmarked to the 10-year GSec rate and they move up and down with the basic benchmark. Therefore, if 10-year GSec rates are high, SSS rates will be up there too, and banks can’t reduce deposit rates without fearing outward flight of deposit money.

So, the yields on 10-year GSecs are fairly central to the transmission story. If the market perceives a loosening of fiscal consolidation, the yields will stay high no matter how soothing the MPC may try to sound on inflation prospects.

Another issue has contributed to holding up GSec yields since 2016-17; this has to do with the National Small Savings Fund (NSSF), the fund in the public account into which SSS deposits flow. Traditionally, NSSF loans went to state governments in proportion to the jurisdiction of small savings collections. To that extent, the reach of states into market borrowings was reduced. Their overall permissible deficit, subject to central control under Article 293(3) of the Constitution, was issuable as securities on financial markets to the extent of amounts residually remaining after automatic borrowings from the NSSF.

But this compulsion to borrow from the NSSF was resented by states, on the grounds that it was a high-cost source of borrowings. The 14th finance commission (FC-14) weighed in on this issue and recommended that states be excluded from NSSF lending. Therefore, ever since 2016-17, redemptions of state government securities owed to the NSSF were not rolled over. These have amounted to around 30,000 crore annually. Replacement borrowing by states for these redemptions will have been obtained through securities issued on financial markets. This would have been over and above net new borrowings to cover the entirety of their (sanctioned) fiscal deficits, instead of just the residual after NSSF borrowings, as before. This incidentally was another reason why analysts saw a sudden rise in the volume of state government borrowings on financial markets starting 2016-17, aside from the transfer of discom debt happening at the same time.

If the central government had moved into the space vacated by state governments in the NSSF portfolio, the overall impact on GSec yields would have been less visible, and that does seem to have happened to some degree, but not enough to fill the portfolio book. Therefore, starting 2016-17, NSSF lending has been extended to an assortment of publicly owned entities like Food Corporation of India (FCI) and even Air India. Up until then, the NSSF had never given out such loans, with the single exception of a 15-year loan in 2007-08 to India Infrastructure Finance Co. Ltd, which was paid off in advance in 2015-16.

If the central government fully takes up the space vacated by state governments in the NSSF portfolio, it would soften the term premium even without fiscal tightening. It would of course raise the interest bill of the centre, which would give it an incentive to reduce small saving deposit rates, although any precipitous reduction would crash the scheme altogether. Most of all, it has to be recognized that the multiple strands linking the NSSF to the fisc need to be fully resolved. Until that is done, the monetary policy agent will not have any control over monetary transmission.