Why monetary transmission is not easy in India

The Reserve Bank of India has always been concerned about the fact that any reduction in the repo rate is not proportionately transmitted in the interest rates for consumers and corporates. The reasons for this, according to this author, are very clear.

The formula for Marginal Cost of Lending Rates (MCLR) is prescribed by the Reserve Bank of India (RBI). There are three components of MCLR, viz. Marginal Cost of Borrowings, Return on Net Worth and Operating Costs. Marginal Cost of Borrowings comprises weighted average of the card rates on deposits and actual weighted average cost of borrowings as on the date of fixing monthly MCLR. Ninety two per cent weightage is assigned to deposits and borrowings, while the balance weightage of 8 per cent is assigned to Net Worth. Actual operating costs are also added. It is observed that the percentage of funds borrowed by banks at the repo rate is very low.  In the past six months, it has remained as low as around 2.5 per cent.The interest which a bank has to pay on the borrowings is clearly a function of three main factors. First is the available liquidity in the economy. Second is the rate of return on competing financial products such as small savings and debt mutual funds. The regulatory requirements of banks is the third factor.

Let us talk about liquidity. In a growing economy, the growth rate of demand for credit is more than the growth rate of deposits. To quote an example from Bank of Baroda, in FY 2019, domestic deposits grew only by 10.9 per cent, while domestic advances grew by 14.2 per cent. Eventually, the gap has to be filled by higher cost borrowings. With the loans being disbursed by NBFCs reducing, there is a greater demand on banks to give loans. The Incremental Credit to Deposit Ratio (ICDR) was 0.43 in FY 2018, which increased to 0.71 in FY 2019, which indicates that the credit demand has gone up. On the other hand, bank deposits have reduced over a period because of a drop in the net domestic financial savings rate to 7 per cent of GDP now, compared to more than 10 per cent at the beginning of the decade. This partly is a reflection of the preference among the young generation to spend more of the disposable income instead of saving. The currency in circulation has again increased now, thus reducing funds available in the banking system. The regulatory requirement of maintaining the SLR, CRR and LCR also reduces the flow of funds available with banks to lend.

Banks face tough competition in attracting deposits. In FY 2019, the Post Office deposit rates for five years, one year, two years and three years went up by 40, 40, 30 and 10 basis points respectively. So banks also had to increase their deposit rates almost at the same rate or at slightly reduced rates. Nowadays, the investors who are returns-conscious invest in Debt Mutual Funds such as Fixed Maturity Plan (FMP) etc. Therefore, in spite of repo being cut, the bank's borrowing costs are not going down.

In the calculation of MCLR, the assumed return on Net Worth computed by banks presently comes to about 17 per cent, which carries a weightage of 8 per cent in MCLR computation.
 

 

Is there any other way by which the monetary transmission can be faster and the interest rates for loan can come down? Maintaining sufficient liquidity in the money market can soften the interest rates. That will reduce the cost of borrowings for banks and NBFCs. Second, the government can downwardly revise the deposit rates on small savings regularly as per the market rate, which makes it easy for banks also to reduce their rate of deposit. The real interest rate in India is still the highest among major economies at about 3.6 per cent. Third, the transmission of repo rate is faster in case of short-term bonds. It would be useful for governments also to plan more of short duration and/or floating rate G-SEC bonds instead of 10-year bond which is now a preferred option. Short-term G-SEC will also ensure that if the interest rates are coming down, the cost of borrowings will also come down for government, and the monetary transmission will be faster.

Next, the development of a vibrant corporate bonds market can help in faster monetary transmission. In order to encourage this, the RBI could think of opening a window of lending to banks at repo rate against the securitisation of portfolio of corporate bonds held by banks. This would encourage companies and banks to use alternative lending mechanism in the form of corporate bonds instead of loans. The RBI has to find ways of improving liquidity of the NBFC sector, which can also result into softening of interest rates. Finally, all banks have to find ways of reducing their operating expenditure, so that the MCLR is reduced.

To conclude, any solution to the problem of monetary transmission can come only if we look beyond the demand for reduction in repo. This is not to say that reduction in policy rates is not called for.

The writer is non-executive chairman of Bank of Baroda