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Monetary levers big and small

When monetary transmission through the big levers is obstructed, other small levers may work to curtail inflation and enhance growth

Indira Rajaraman 

Indira Rajaraman

Monetary policy operates through the big levers: the repo and reverse repo rates, the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). These signal the intent of the central bank.

The transmission of these signals to the lending end of commercial banks requires a lot of little connections, nuts and bolts, to be in working order for the eventual intent to be realised. Sadly, unlike a Rube Goldberg cartoon, where the ultimate purpose is something laughably trivial, like activating a napkin to wipe someone's mouth after each spoonful of food, the intent of monetary policy is the deadly serious business of stabilising the economic environment. In the cartoon, we get to observe what the napkin does. In the case of monetary policy, the official data as reported at present simply do not help to assess the speed and extent of transmission to borrowers from the banking system.

Monetary transmission in India tends to be asymmetric, because deposits held by the public with commercial banks are locked in at fixed rates for long maturities of as much as five years. When the policy rate goes up, banks happily follow suit with lending rates. When the policy rate goes down, lending rates are sticky downwards, because deposit rates cannot be reduced immediately. In the present situation, where deposit inflow into banks has already slowed because interest rates are not sufficiently attractive relative to inflation, transmission is that much more obstructed.

The principal problem though is that the information base for assessing transmission is weak. Bank lending rates are reported only as a weighted average, or range, across the entire stock of loans outstanding. What we need to know instead is the rate on incremental loans in each quarter, incremental in the sense of new loans extended in that quarter. Even if lending rates on new loans do fall, the weighted average across the entire stock of loans might not budge, thus suggesting that no transmission has taken place - when in fact it may well have, on new loans at any rate.

Banks also report something called a base rate to which lending rates are pegged, but what matters to a borrower is the margin fixed above the base rate. A downward base rate adjustment in response to a repo reduction does not mean that pre-existing borrowers automatically reap the advantage. They should, in principle, unless their credit rating changes in the opposite direction in the interim; but, without data, we simply do not know what the banks actually do. And in all fairness, if borrowing rates are floated to a base rate, so should deposit rates.

Borrowers vary in their credit ratings, and consequently, the rate at which they can borrow. Even a weighted average across incremental loans will, by definition, weight the big, and hence highly creditworthy, loans more than the small. A fall in the weighted average on incremental loans (assuming such a measure were reported, which is not the case at present) can seem like a repo rate reduction is being transmitted, when in fact it is not being felt at all at the small end. And the small end is where it matters, for a spatially dispersed impact on the economy.

A median gets rid of that problem. And a median of medians across banks on incremental loans by class of loan will tell us what we really want to know: whether loans are becoming cheaper to the average borrower. Thus, for example, in order to assess the impact of a reduction in the repo rate of say 25 basis points, we need to know what the median impact was on new project loans, and at the other end, on small loans to priority sectors.

Discretion and confidentiality in risk assessment and rates charged are absolutely essential if banks are to perform their intermediation task effectively. None of this is threatened by requiring more disclosure in the reporting system of commercial banks. We merely seek to know whether, and with how much of a lag, alterations in the monetary policy stance reach the borrower.

The borrower from the formal financial sector, that is. The aam aadmi has no truck with the formal banking system. No matter how frenetically direct bank transfer of benefits under various schemes might be promoted, the leap from that to actually being able to borrow from a bank in rural areas is impossible, except for landowning holders of Kisan Credit Cards.

As for the urban sector, despite the density of bank outlets, the reach of formal finance is pathetically limited. Delhi and many other urban centres have weekly markets in even the most upscale residential areas, a kind of mobile supermarket which comes to the customer. On designated days of the week, a few roads in the locality are closed off and sprout pushcarts selling everything from vegetables to kitchen utensils and clothing.

The very mobility of these vendors means that they cannot deal with the documentary requirements of the formal banking system. The informal financial system reportedly charges an astronomical 10 per cent per day on working capital loans to these vendors. This creates a huge wedge between the retail price paid by consumers and the price received by producers. If formal bank finance could bring overnight loans to small vendors through mobile units even at rates at the high end of the formal spectrum, this wedge will collapse. Group enforcement should ensure close to zero default.

A radical outreach of this kind by banks does of course require that they reconfigure their operating procedures so as to permit mobile lending and deposit collection operations. The need for them to do so is surely staringly obvious, in a country where exclusion from formal finance is not a marginal phenomenon, and at a time of stubbornly high retail food inflation.

The larger structural constraints on the supply side of agriculture will remain. But there will be immediate rewards to worshipping at the shrine of small things.

The writer is a retired professor of economics

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First Published: Mon, May 13 2013. 21:51 IST