RBI policy: Raghuram Rajan’s rate cuts have been useless till now. Here’s why

I like to often quote the American baseball coach Yogi Berra in pieces that I write, given that a lot of what he has said makes so much sense. One of Berra’s most famous quotes (which I have also used on numerous occasions) is: “In theory there is no difference between theory and practice. In practice there is.”
Raghuram Rajan, the governor of the Reserve Bank of India(RBI), more or less stated the same in the first monetary policy of this financial year, which was released today. Rajan decided to keep the repo rate at 7.5%. He has cut the repo rate twice this year, first in January and then in March. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
But these cuts amounting to a total of 50 basis points (one basis point is one hundredth of a percentage) have not been passed by the banks.
A recent Bloomberg newsreport pointed out that 43 out of the 47 scheduled commercial banks haven’t cut their base rates or the minimum interest rate a bank charges its customers. This means that EMIs on loans will continue to remain high.
Theoretically one expects banks to cut their lending rates after the RBI has cut its repo rate twice. But that hasn’t happened. As Rajan put it in the monetary policy statement: “Transmission of policy rates to lending rates has not taken place so far despite weak credit off take and the front loading of two rate cuts.” Offering this as a reason, Rajan and the RBI decided to maintain the repo rate at 7.5% in the monetary policy announced today.
Lending by banks has grown by a minuscule 9.5% in the last one year, data from the RBI points out. In comparison, the growth in deposits collected by banks has been at 11.4%. What also needs to be taken into account here is that the deposit growth has been on a higher base.
Hence, deposits have been growing at a much faster rate than loans. Theoretically, this should have led to banks cutting interest rates so that more people would borrow. But that hasn’t happened. There are multiple reasons for the same.
In order to cut their lending rates, banks need to reduce their base rate or the minimum interest rate that a bank charges to its customers. When a bank cuts its base rate, the interest rates that it charges on all its loans, fall. But the interest that it pays on its deposits do not work in the same way.
When a bank cuts the interest rate on its fixed deposit, only fixed deposits issued after the cut, get paid a lower rate of interest. The fixed deposits issued before the cut continue to be paid a higher rate of interest. While the interest a bank earns on its loans is floating, the interest it has to pay on its deposits is not. Hence, banks are reluctant to cut their lending rates even though the RBI has indicated to them very clearly that it is time that they started to do so.
Over and above this, most public sector banks have huge bad loans to deal with. And cutting interest rates would mean taking the risk of lower profits, hence, status quo is the preferred way.
Further, it might be worth pointing out here that it takes time for the impact of the RBI rate cuts to trickle down. A recent report by the International Monetary Fund (IMF) makes this point: “Pass-through to deposit and lending rates is relatively slow and the deposit rate adjusts more quickly to monetary policy changes than does the lending rate.”
The report further points out that it takes around 18.8 months (a little over one and a half years) for the lending rates to change. The deposit rates change in 9.5 months. Once these data points are taken into account it is easy to conclude that the two repo rate cuts by the RBI in January and March 2015, will take time to trickle down.
That just about answers the question why the repo rate cuts by the RBI haven’t benefited the end consumers. The next question I try and answer in this piece is what will it take for the RBI to cut the repo rate again?
As Rajan said in the press conference after the announcement of the monetary policy: “You shouldn’t expect direction to change in future.” What he was basically saying here is that the RBI remains on course to keep bringing down the repo rate in the days to come.
And what will it take for the central bank to do that? The monetary policy statement has the answer: “The Reserve Bank will await the transmission by banks of its front-loaded rate reductions in January and February into their lending rates. Second, developments in sectoral prices, especially those of food, will be monitored, as will the effects of recent weather disturbances and the likely strength of the monsoon, as the Reserve Bank stays vigilant to any threats to the disinflation that is underway.”
Unseasonal rains in North India have damaged a lot of
rabi crop. A March 27, 2015, press release by the ministry of agriculture points out: “As per the latest reports received from States, the area under rabi rice as on today stands at 39.43 lakh hectare as compared to 43.55 lakh hectare at this time last year. Total area under rabi rice and summer crops moves to 52.20 lakh hectare as compared to 55.28 lakh hectare at this time last year.” Pulse is another important rabi crop.
This crop damage is expected to push up food prices to some extent. An increase in the price of rice can be curtailed if the government chooses to release some of the huge stock of rice that it has. As on March 1, 2015, the government had a wheat stock of 195 lakh tonnes.
What will also help curtail food inflation is the fact that rural wage inflation has been on its way down for a while now. One of the major reasons that food prices were high between 2008 and 2013 was the rapid increase in rural wages.
As Chetan Ahya and Upasana Chachra of Morgan Stanley point out in a recent research note: “In the 2008-13 period, we believe intervention in the labour market artificially pushed rural wage growth to 18-20% year on year. With wages accounting for 50% of operating costs in food production and higher income growth into hands of rural labour without matching the increase in productivity, the rapid rise in wage growth resulted in persistently high inflation.”
But this increase is now a thing of the past. “The good news is that rural wage growth has been on a decelerating trend over the past 13 months as government intervention in rural labour markets has reduced. Since Jan-14, rural wage growth has decelerated at a quick pace and currently averages 6.2% for the 12 months ending Jan-15, compared with 16% for the 12 months ending Jan-14. Moreover, the latest data shows rural wage growth at 5.5% in Jan-15 – near a 9- year low,” the report points out.
This will ensure that food inflation spikes will be controlled in the days to come. And that should give some more space to Rajan to cut the repo rate.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on April 7, 2015