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

ARTS RAJAN
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

Why banks still haven’t cut interest rates

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010
Vivek Kaul

Today is the first day of the new financial year. And banks still haven’t cut interest rates. This despite the Reserve Bank of India(RBI) of cutting the repo rate twice by 50 basis points (one basis point is one hundredth of a percentage) between January and March 2015. 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.
Other than the RBI cutting the repo rate, the finance minister has also been very vocal about the entire issue.
On March 22, 2015, he remarked:We do not put pressure on them (i.e. public sector banks) We only expect and our expectations come true.”
A few days later on March 25 2015, Jaitley said: “I mentioned a few days ago in the presence of the (RBI) Governor (Raghuram Rajan) that we do not pressurise the banks to cut rates. But we do expect the banks after assessing the situation to act in a prudent manner. Our banks have been by and large responsible. And I am quite certain we will see more cuts in future.”
Despite this overt pressure, the banks haven’t gone around cutting the interest rates on their loans.
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.
Unless, banks cut their base rate there is no point in the RBI cutting the repo rate simply because the borrowers as well as the prospective borrowers do not benefit from lower interest rates. Having said that, just because the RBI has cut the repo rate or the fact that the finance minister thinks interest rates should be lower, doesn’t mean that banks should lower interest rates. One thing that they need to look at is their deposit growth vis a vis their loan growth. Latest data from the RBI suggests that deposit growth over the last one year was at 11.6%. In comparison, the loan growth of banks was at 10.2%. Also, the deposit growth was on a higher base. Hence, it is safe to say that deposits of banks have grown much faster than their loans.
This conclusion can also be made by calculating the incremental credit deposit ratio. The incremental credit deposit ratio over the last one year stands at 67.3%. This means that for every Rs 100 raised as deposit, banks have given out loans worth Rs 67.3. Ideally, banks should be lending around Rs 74.5 for every Rs 100 they raise as a deposit. This, after adjusting for the Rs 25.5 of Rs 100 that they need to maintain as cash reserve ratio and statutory liquidity ratio.
Around this time last year, the incremental credit deposit ratio had stood at 73.7%. Hence, what this clearly tells us is that lending by banks is growing at a significantly slower pace in comparison to the increase in deposits. Given this, banks should be in a position to cut their base rate, but they still haven’t.
Why? While banks are quick to raise interest rates when the RBI raises the repo rate, they are slow to cut interest rates when the RBI cuts the repo rate. Also, if banks lower their base rate, the interest they earn on the money that they have lent comes down immediately. But the interest that they pay on their deposits does not change. While loans rate are floating, deposit rates are not. Hence, banks continue to hold on to interest rates on their loans.
As a March 11 report by the International Monetary Fund on India points out: “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.” What this means is that after the RBI cuts the repo rate, banks tend to cut their deposit rates more quickly in comparison to their lending rates. Further, it takes around 9.5 months for deposit rates to change and 18.8 months for the lending rates to change,after the RBI has cut the repo rate, the IMF stated. Given this, it will be a while by the time banks start to cut their lending rates. And this assuming that the RBI does not change its direction on repo rate cuts.
What has not helped is the fact that banks continue to accumulate bad loans. As the IMF report on India points out: “Evidence of corporate India’s worsening financial performance is found in the rising share of stressed loans in banks’ portfolios—both non-performing assets (NPAs) and restructured loans have continued to increase, and are at their highest levels since 2003…Corporates in the manufacturing and construction sectors, plus the infrastructure sector, contributed notably to banks’ non performing assets. Between 2002/03 and 2013/14 corporate debt increased by 428 percent for a sample of 762 firms.”
With such high levels of borrowing the pressure on the balance sheets of banks (in particular public sector banks) is likely to continue in the days to come. As the IMF reports points out: “Some corporates are likely already credit constrained due to high leverage, which in turn continues to put pressure on the health of the financial system, in particular on the balance sheets of public sector banks (PSBs). This will further affect bank risk taking as well as the ability of the banking system to finance economic recovery.”
The bad loans will also limit the ability of banks to cut their lending rates. As Crisil Research pointed out in a recent report: “High non performing assets curb the pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs – such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) – are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort.”
Given this, the finance minister Jaitley may keep asking banks to cut their lending rates, but the banks are not likely to oblige him any time soon.

The column was originally published on The Daily Reckoning on April 1, 2015