The efficacy of monetary policy is judged
by the promptness and extent with which it achieves intended outcomes, such as
reducing inflation or increasing economic growth. By changing the policy rate,
for instance, a central bank seeks to affect money market rates, which then
transmit the policy impulse to the full spectrum of deposit and lending rates
in the financial system. This in turn affects consumption, saving and investment
decisions and eventually demand and inflation. In India, as in other emerging
markets, the interest rate is the most commonly used instrument. However, other
ways are also available. These include the credit channel which works by constraining
the supply of bank loans; the asset price channel which involves influencing other
asset prices like equity and real estate; and finally, the exchange rate
channel which influences the relative attractiveness of domestically produced
goods vis-Ã -vis imports for consumers.
Since January 2015 when the current phase
of monetary easing commenced, there have been endless debates over the pace and
magnitude of rate cuts carried out by the Reserve Bank. For instance, during
the 16-month period from January 2015 and April 2016, the RBI effected a
cumulative reduction of 150 bps in the repo rate. Over the next 16 months, it
cut rates by only 50 basis points more despite the fact that inflation dropped
substantially while investment remained sluggish. As we have pointed out in our
briefings to clients, one reason for its caution was the fact that US dollar
interest rates were rising, creating a risk of capital outflows and rupee depreciation
in the event of narrowing rate differentials between India and America. A
second reason perhaps is the fact that the central bank remains unconvinced
that inflationary risks have fully subsided. But a third and more structural one
is the inefficiency of the domestic monetary transmission system.
Reduction in
banks’ lending rates during Jan 2015-April 2016 (outstanding rupee loans)
|
|
Repo rate
|
150 bps
|
Agriculture
|
16 bps
|
Industry
|
78 bps
|
MSMEs
|
97 bps
|
Infrastructure
|
85 bps
|
Trade
|
110 bps
|
Professional services
|
75 bps
|
Housing
|
26 bps
|
Vehicle
|
44 bps
|
Education
|
58 bps
|
Credit card
|
40 bps
|
Other
|
28 bps
|
Export credit
|
99 bps
|
Source: RBI Annual Report 2015-16
|
In simple terms, this means that the cuts
effected so far in the headline policy rate have not led to proportionate declines
in final lending and deposit rates across the financial system. Until that
happens, the central bank can neither assess the efficacy of earlier actions nor
gauge the extent of further rate cuts required. For instance, in response to
the 150 bps reduction in the repo rate during the first phase of easing between
January 2015 and April 2016, the median deposit rates of banks declined by only
92 basis points while their base lending rate declined by a mere 60 bps. In
terms of the weighted average lending rate (WALR), there was a reduction of 100
bps in fresh rupee loans but only 65 bps on outstanding rupee loans, which
comprise the majority of the total stock of loans. In terms of industry
segments, the highest extent of transmission has occurred in the trade segment
of Services where lending rates declined by 110 bps and rupee export credit whose
rates fell by 99 bps. On the other hand, agriculture and home loans have seen
the least transmission, with average declines of only 16 and 26 bps in lending
rates (see table).
The factors that constrain the transmission
of monetary impulses constitute an entire subject by itself. Briefly, however,
these stem from two broad areas. The more important of these is fiscal
dominance. In order to fund the central Government’s fiscal deficit, the RBI
issues securities in the open market. However, it uses SLR regulations to
compel banks to subscribe to such securities and effectively supresses artificially
the cost of borrowings for the Government. Further, it uses its open market
operations (OMO), which are technically meant to manage liquidity, to also manage
yields on Government securities when large borrowing rounds are about to be
undertaken. Under OMO, the central bank buys and sells securities in the
secondary market with the aim of injecting or absorbing liquidity in the
banking system. However, it cleverly uses this route to bring down yields ahead
of large new bond issuances. It does this by buying securities thereby raising
bond prices and depressing yields. The net effect of these actions is to dampen
the transmission of monetary impulses across the term structure. Additionally, extraneous
fiscal decisions such as maintaining fixed or near-fixed interest rates on
small savings schemes, offering interest rate subventions on agricultural or
other loans, loan waivers, etc also erode the effect of policy rate actions.
The second factor is the presence of a large
informal financial sector. Large sections of households and small businesses
borrow from moneylenders and other non-institutional sources. These typically
charge rates of 18-36% per annum, multiples of the cost of formal bank
borrowings. These rates are understandably far less responsive to policy rate
changes than those charged by banks. Moreover, incremental changes in these
rates, in any event, constitute only a small fraction of the total borrowing
cost, rendering the impulse ineffective.
In all these areas, efforts have been made
to improve monetary transmission. However, many decisions are not within the
purview of the central bank and require the cooperation of the Government. A
committee has been tasked with the job of identifying the required interventions
and is expected to submit its report in September 2017. One might hope that a
cohesive strategy to implement the measures would then be drawn up. If that
were to happen, it would make India’s monetary architecture more responsive.
Consequently, monetary policy would become more effective and predictable.
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