The logjam in rate transmission

The gap between lending rates and RBI's repo rate has reached levels only seen in crises

Transmission of interest rates, or rather, the lack of it, is now in a crisis-like situation. The gap between the average bank lending rate (by this we mean the weighted average lending rate or WALR on outstanding rupee loans, as reported by the Reserve Bank of India) and the repo rate (which the RBI sets) is now the widest on record. This gap has built up mostly in the last 15 months: Between January 2015 and August 2018, the average bank lending rate fell by the same amount as repo rate. It is since August 2018 that the bank lending rates have barely moved despite 135 basis points of repo rate cuts.

Some of this is the normal time lag for the rate cuts, which first affect new loans, to seep through into the overall loan-book. The gap between rates on new loans and those on outstanding loans (the flow versus the stock, so to say) has increased slightly, but in our view that is primarily due to the short-lived rate-hike cycle we saw last year, where the repo rate had risen from 6 per cent to 6.5 per cent between June and August 2018. When this happened, the rates on fresh loans, which broadly track the bank’s cost of funding, first began to rise, and are now falling: Somewhat like turning a very large ship, it takes a while to change direction, and rates should fall in the next few quarters as the recent repo rate cuts flow through. However, the gap between repo rates and those on fresh loans is now inexplicably wide, and may not adjust meaningfully. The switch to external benchmarks that the RBI enforced starting October may help speed up transmission of future rate cuts, but would not help transmit the cuts already made.

Many instinctively assume this as banks profiteering, but there is little evidence of that. The gap between the lending rate on fresh loans and that based on the marginal cost of funds (MCLR) is within the historical range. The reported net interest margins of banks have also not expanded meaningfully.

There is a similar problem of rate transmission in the bond markets, too. The heightened credit-spread due to risk-aversion in bond markets has been well documented: For example, among non-banking finance companies (NBFCs), the gap between the rates at which the firms considered “safe” are borrowing, and those considered at-risk, has continued to widen over the past year.

But equally problematic has been the elevated term premium, that is, the gap between the long-term risk-free rate (as represented by yields on the 10-year government bond) and the short-term risk-free rate (that is, the repo rate). Not only is this spread much wider than it has been historically, it is now the widest globally, again pointing to some serious problems.

On the face of it, this may seem to be due to a lack of demand for bonds from foreign portfolio investors (FPIs), but the problem has other facets too. Over the past decade, the RBI has been steadily bringing down SLR limits (that is, the percentage of deposits that banks must park in government bonds), and raising FPI limits by a broadly similar amount. Till about a year back, this was working, as banks’ share of government bonds fell, and that of FPIs, domestic insurance companies and RBI increased. Over the past year, however, FPIs have largely stayed away despite high real-yields, and the increase in the share of RBI has been offset by the drop in the share for banks. In a relative sense, the RBI has bought, and banks have sold. Till a month back, banks were selling government bonds to generate liquidity for lending.

illustration: Binay Sinha

The wide gap that has recently opened up between time deposit rates and the repo rate, in our view, is another symptom of the problem. The friction caused by the government’s reluctance to cut small savings rates is only a part of the explanation (it affects only about 10 per cent of incremental deposits annually). 

In our view, the root cause for the weak transmission in both banks and bond markets is weak money supply. Broad money (measured by M3, which is mainly the sum of currency in circulation, deposits in banks and banks’ deposits with the RBI), has been growing at around 10 per cent annually for the last three years. For an economy that expects to grow at 11 to 12 per cent annually in nominal terms, this is too low. Given that formalisation of more than 40 per cent of the economy that is informal is a policy objective, money supply needs to grow faster. However, even as de-risking in the financial system has brought down the money multiplier since Sep-2018, growth in base money (measured by M0, something that the RBI controls) has now slowed to just 12 per cent year-on-year. 

As effective interest rates in the bond and bank markets are not coming down despite repo rate cuts, and the economy continues to slow, it is not surprising that system credit growth has fallen well below 10 per cent (this includes all forms of domestic credit: Banks, NBFCs and bonds). This growth was nearly 15 per cent  till a year back. The decline in credit growth is both due to demand, as high interest rates discourage loan demand, and also due to supply: At this stage of the economic cycle, where growth expectations are being revised downward, it is rational for financial firms to tighten credit standards and bring down loan growth targets, and they are doing so. Rejection rates for auto loans, for example, have picked up and risk officers in mutual funds continue to discourage purchase of even marginally risky bonds. 

If the growth in system credit  as well as broad money supply stays in single digits, it is hard to envision a sustained recovery in economic momentum. The challenge for policy-makers is to ensure that borrowing rates come down in line with the drop in nominal growth rates. This may not occur till a force is applied to break through the logjam in rate transmission through banks and bond markets. While counter-cyclical changes to macro-prudential policy easing can be an option, the credit spread in banks and bond markets would be hard to influence through policy. However, policy-makers can and perhaps should increase the pace of base money supply, may be by buying government bonds in sizeable quantities.

The writer is India Strategist and co-head of Asia-Pacific Strategy for Credit Suisse