The curious case of monetary policy transmission in India

Encouraged by a lower CPI inflation trajectory, the Reserve Bank of India (RBI) has cut the repo rate by 50 basis points (bps) in the first quarter of FY15. While longer-tenure bond yields have reduced significantly, the transmission from a repo rate cut to lower bank lending rates has not materialised yet, due to the following factors.

Asymmetry in monetary policy transmission
Banks find it more difficult to cut lending rates immediately after a cut in the policy rate because the cost of deposits does not adjust commensurately and immediately, given the fixed nature of deposit contracts. However, banks can raise lending rates far more quickly after a policy rate hike, because loans are mostly at variable rates, and can be re-priced faster. There is a competitive constraint of reducing deposit rates too much and too quick as well. If bank deposit rates are lower than small savings rates which are administratively fixed, there could be some deposit flight to small savings schemes providing higher returns.

Reflection of risk-averse behaviour
The banking system continues to be under stress due to rising non-performing assets (NPAs), which along with restructured assets are estimated at about 10 per cent of total assets currently. The stressed loans are concentrated across five key sectors - infrastructure, iron and steel, textiles, aviation and mining - which constitute 24 per cent of total advances and 52 per cent of total stressed advances. Given this backdrop, it is natural to expect banks to be risk-averse and show reluctance in lending further to these sectors.

Lack of demand for credit
While the banks are not that eager to lend, the demand for credit from corporates also remain low, due to balance sheet concerns, difficulty in acquiring land for fresh green-field projects, low capacity utilisation and lower working capital loan requirement, helped by falling global oil prices.

Tight liquidity condition
Some commercial banks have argued that a cash reserve ratio (CRR) cut is required to make the monetary transmission effective. Currently, commercial banks have to maintain four per cent CRR with RBI, on which they do not earn any interest. A meaningful cut in the CRR will not only help inject additional liquidity into the system, thereby freeing resources to lend, but also help banks to pass on rate cuts without taking a hit on their net interest margin. Currently, the CRR is at an all time low of four per cent, though there is no hurdle to bring the rate further down. The broader argument for a CRR cut, apart from helping banks maintain their profitability, is as follows: during a rate hike cycle, if liquidity needs to be tightened to ensure effective transmission, shouldn't liquidity deficit be eased considerably to ensure smooth transmission in a rate cut cycle?

The bottom line is that even if monetary policy moves are transmitted with some lag, banks are unlikely to match RBI's rate cuts. In the last easing cycle (April 2012-June 2013), a 125 bps cut in the repo rate, along with a 200 bps cut in the CRR (Jan 2012-June 2013) led to a bank-base rate reduction of just 50 bps. Clearly, more rate cuts and liquidity support measures would be needed to nudge banks towards lower rates in the coming months.

The author is the India Economist of Deutsche Bank AG. The views expressed are personal