Why RBI is Doing Dhishum Dhishum With Bond Market

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody. – James Carville.

The Reserve Bank of India (RBI) is unhappy with the bond market these days. Well, it hasn’t said so directly. A central bank rarely does. But a series of newsreports across the business media suggests so. (Oh yes, the RBI also leaks when it wants to).

The bond market wants the RBI to pay a higher yield on the government of India bonds it is currently issuing. The cost of the higher yield will have to be borne by the government of India, something that the RBI doesn’t want.

And this is where we have a problem (don’t worry I will explain this in simple English and not write like bond market reporters or experts tend to, for other bond market reporters and other bond market experts). Government bonds are financial securities which pay an interest and are issued by the government in order to borrow money.

Let’s try and understand this issue pointwise.

1) The government’s gross borrowings for 2020-21, the current financial year, had been budgeted at Rs 7.8 lakh crore. In May 2020, after the covid pandemic broke out and the tax collections crashed, the number was increased to Rs 12 lakh crore. The final borrowings are expected to be at Rs 12.8 lakh crore. In 2021-22, the gross borrowings of the government are expected to be at Rs 12.06 lakh crore.

Hence, over a period of two years, the government will end up borrowing close to Rs 25 lakh crore. It isn’t surprising that the bond market wants a higher rate of return or yield as it likes to call it, from government bonds, given that the financial savings in the country will not expand at the same rate as government borrowing is expected to. Also, there is no guarantee that the government will stick to borrowing what it is saying it will borrow. That’s a possibility the market is also discounting for.

2) Take a look at the following chart which plots the 10-year bond yield of the government of India. A 10-year bond is a bond which matures in ten years and the return on it on any given day is the per year return an investor will earn if he buys that bond on that day and holds on to it until maturity.

Source: www.investing.com

As can be seen from the above chart, the 10-year bond yield has largely seen a downward trend since January 2020, though since January 2021 it has gradually been rising. As of the time of writing this, it stood at 6.14%, having crossed 6.2% on February 22.

Media reports suggests that the RBI wants the yield to settle around 6%. The bond market clearly wants more. This explains why in the recent past bond auctions have failed with the bond market not buying bonds or the RBI refusing to sell them at yields the bond market wanted.

3) The question is why does the bond market now want a higher rate of return on bonds than it did in 2020. There are multiple reasons for it. Bank lending has largely collapsed during this financial year and has only improved since October. Between March 27, 2020 and January 29, 2021, the overall bank lending has grown by just Rs 3.34 lakh crore, with almost all of this lending carried out during the second half of the financial year.

This forms around 27% of the deposits of Rs 12.3 lakh crore that banks have managed to raise during the period. Clearly, the banks haven’t been able to lend out a large part of their fresh deposits.

Hence, it has hardly been surprising that a bulk of the bank deposits have been invested in government bonds. During the period Rs 6.94 lakh crore or 56% of the deposits have been invested in government bonds. Along with banks, other financial institutions have had few lending/investment opportunities, leading to a lot of money chasing government bonds, which has led to lower returns on them.

Over and above this, the RBI has flooded the financial system with money by cutting the cash reserve ratio (CRR) and by also printing money and buying bonds (something it refers to as open market operations), thereby driving down returns further.

4) What has changed now? The budget expects India to grow by 14.4% in nominal terms (not adjusted for inflation) in 2021-22. Even in real terms (adjusted for inflation), India is expected to grow by at least 10%. This basically means that bank and other lending will pick up. At the same time, the government borrowing will continue to remain high at Rs 12.06 lakh crore. Hence, there will be more competition for savings in 2021-22 than has been the case during this financial year, given that savings are not going to rise suddenly. Hence, yields or returns on government bonds need to go up accordingly. QED.

5) There is another point that needs to be made here. Thanks to the RBI wanting to drive bond yields and interest rates down, there is excess liquidity in the financial system right now. Lending to the government is deemed to be the safest form of lending. If lending to the government becomes cheaper, interest rates on everything else also tends to go down.

As of February 23, the excess liquidity in the financial system stood at Rs 5.7 lakh crore. This is money which banks have parked with the RBI.

On February 5, the RBI governor, Shaktikanta Das, had said: “A two phase normalisation of the cash reserve ratio (CRR) – which I am going to announce – needs to be seen in this context.”

The banks need to maintain a certain proportion of their deposits with the RBI. It currently stands at 3%. In April 2020, the RBI had cut the CRR by 100 basis points to 3%. One basis point is one hundredth of a percentage. With the banks having to maintain a lower proportion of their deposits with the RBI there was more liquidity in the financial system, which helped drive down yields and interest rates.

Now the RBI wants to increase the CRR in two phases. Assuming it wants to increase the CRR to 4%, this means that more than Rs 1.56 lakh crore (using data as of February 23) will be pulled out of the financial system by banks and be deposited with the RBI, in the months to come.

The bond market is discounting for this possibility as well, even with Das saying: “systemic liquidity would, however, continue to remain comfortable over the ensuing year.” What this basically means is that the RBI will continue to carry out open market operations by buying bonds and pumping money into the financial system as and when it deems fit.

Having said that, the overall liquidity in the financial system will go down, simply because once the RBI withdraws more than Rs 1.56 lakh crore through raising the CRR, it isn’t going to pump in the same amount of money back into the system, through open market operations, simply because then there would have been no point in increasing the CRR.

6) If your head is not spinning by now, dear reader, then you are clearly a bond market veteran. (Now isn’t the stock market so much simpler). Basically, the RBI is trying to play two roles here. It is the government’s debt manager and banker. At the same time, it also has the mandate of maintaining the rate of consumer price inflation between 2-6%. And at some level these objectives go against each other.

As the government’s debt manager, the RBI needs to ensure that the government is able to borrow at lower rates. In order to do that the RBI now and then floods the system with more money and drives down rates.

The trouble with flooding the system with more money in an economy which is recovering from a huge economic shock, is higher inflation as there is the risk of more money chasing the same amount of goods and services. Of course, with the manufacturing sector having a low capacity utilisation, they can always start more machines and pump up more goods, and ensure that inflation doesn’t shoot up. But the risk of inflation is there, given that money supply (M3) as of January 29, had gone up by 12.1%, year on year.

Over the years, there has been a lot of debate around whether the RBI should continue being the debt manager to the government or should that function be split up from the central bank and another institution should be created specifically for it, with the RBI just concentrating on managing inflation. I guess, in times like the current one, this suddenly starts to make sense.

7) Okay, there is more. The yield on the 10-year US treasury bond has been rising and as I write it has touched 1.33% from around 0.92% at the end of 2020. A major reason for this lies in the fact that the bond market is already factoring in the plan of the newly elected American president Joe Biden to spend more money in order to drive up economic growth.

Of course, with bond yields rising in the US, there is bound to be an impact everywhere else, given that the American government bond is deemed to be the safest financial security in the world. This has added to further pressure on the yields on the Indian government bonds.

8) After the finance minister presented the budget, the bond market realised that the government has huge borrowing plans even in 2021-22 and that even this financial year it would borrow Rs 80,000 crore more than the Rs 12 lakh crore it had said it would.

Accordingly, the 10-year bond yield moved up from 5.95% on January 29 to 6.13% on February 2, a day after the budget was presented. The RBI carried out open market operations worth Rs 50,169 crore between February 8 and February 12, on each of the days, to increase the liquidity in the financial system and push the yield below 6% to 5.99% on February 12.

But the yields have gone back up again and stand at 6.14% at the point of writing this. Interestingly, the yields on state government bonds have almost touched 7.2%.

Clearly, the bond market has made up its mind as far as yields are concerned. The way out of this for RBI is to print more money and buy more government bonds and drive down yields. Of course, this needs to be done regularly and by following a certain routine.

That’s the trouble with printing money. A major lesson in economics since 2008 has been that printing money by central banks leads to printing of more money in the time to come, given that the market gets addicted to the easy money.

Let’s see how the RBI comes out of this predicament, given that it has promised an “accommodative stance of monetary policy as long as necessary – at least through the current financial year and into the next year”.

9) We aren’t done yet. Other than being the debt manager to the government and having to manage the consumer price inflation between 2-6%, the RBI also needs to keep a look out for the dollar rupee exchange rate.

During the course of this financial year, the foreign institutional investors have brought in $35.4 billion to invest in the stock market. When they bring money into India they need to sell their dollars and buy rupees. This increases the demand for the rupee and leads to the rupee appreciating against the dollar.

When the rupee is appreciating against the dollar, the RBI typically sells rupees and buys dollars, in order to ensure that there is enough supply of rupees going around. In the process, the RBI ends up building foreign exchange reserves and it also ends up pumping more rupees into the financial system, thereby increasing the money supply, and pushing up the risk of a higher inflation.

Over and above this, the open market operations of buying bonds and cutting the CRR, this is another way the RBI ends up pumping money into the financial system. All this goes against its other objective of maintaining inflation.

One dollar was worth Rs 74.9 sometime in mid-November 2020. It has been falling since then and as I write this, it stands at Rs 72.4. What this means is that in the last few months, the RBI has barely been intervening in the foreign exchange market.

This brings us back to the concept of trilemma in economics, which the RBI seems to have hit. Trilemma is a concept which was originally expounded by the Canadian economist Robert Mundell. Basically, a central bank cannot have free international movement of capital, a fixed exchange rate and an independent monetary policy, all at the same time. It can only choose two out of these three objectives. Monetary policy refers to the process of setting of interest rates in an economy, carried out by the central bank of the country.

This explains why the RBI is letting the rupee appreciate, in order to ensure free movement of capital (at least for foreign investors) and an independent monetary policy. Let’s say the RBI kept intervening in the foreign exchange market in order to ensure that the rupee doesn’t appreciate against the dollar. In this situation, it would have ended up pumping more rupees into the financial system and thereby risking higher inflation in the process.

A higher inflation would have forced the RBI to start raising interest rates in an environment where the economy is recovering from a huge shock and the government is looking to borrow a lot of money. This would have led to the RBI losing control over its monetary policy. Clearly, it didn’t want that. (For everyone wanting to know about the trilemma in detail, you can read this piece, I wrote in September last year).

10) Finally, an appreciating rupee has multiple repercussions. People like me who make some amount of money in dollars, get hit in the process. (I would request my foreign supporters to keep this in mind while supporting me. Okay, that was a joke!)

Further, it makes imports cheaper, going against the entire narrative of atmabnirbharta being promoted right now. If imports become cheaper, the local products will find it even more difficult to compete. Of course, cheaper imports is good news for the consumers, given that the main aim of all economics is consumption at the end of the day.

An appreciating rupee also hurts the exporters as they earn a lower amount in rupee terms, making it more difficult for them to compete globally. And all this goes against the idea of promoting Indian exports and exporters to become a valuable part of global value chains and boosting Indian exports.

To conclude, and I know I sound like a broken record (millennials and gen Xers please Google the term) here, there is no free lunch in economics. That’s the long and short of it. All the liquidity created in the financial system to drive down yields on government bonds to help the government borrow at lower rates, is having other repercussions now. And there isn’t much the RBI can do about it.

Of course, if the bond market keeps demanding higher yields, the RBI’s dhishum dhishum with it will get even more intense in the days to come . If you are the kind who gets a high out of these things, well, continue watching this space then!

There Is Only So Much That Rajan Can Do About Interest Rates


The next Reserve Bank of India(RBI) monetary policy meeting is scheduled on April 5, 2016. Given this, calls for the RBI governor, Raghuram Rajan, to cut the repo rate, are already being made. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. So the question is will Rajan cut the repo rate or not?

Most economists quoted in the media are of the belief that Rajan will cut the repo rate by 25 basis points. Of course that is the safest prediction to make at any point of time when the repo rate is on its way down. One basis point is one hundredth of a percentage.

I guess I will leave the kite-flying to others and concentrate on other things, which I think are more important than guessing what Rajan will do. The impression given by those demanding an interest rate cut is that the RBI actually determines all kinds of interest rates in the economy. But that isn’t really true.

As Mervyn King, who was the governor of the Bank of England (the British equivalent of RBI), between 2003 and 2013, writes in his new book The End of Alchemy—Money, Banking and the Future of the Global Economy: “We think of interest rates being determined by the Federal Reserve, the Bank of England, the European Central Bank(ECB) and other national central banks. That is certainly true for short-term interest rates, those applying to loans for a period of a month or less. Over slightly longer horizons, market interest rates are largely influenced by the likely actions of central banks.”

The point being that the ability of central banks to influence interest rates, at most points of time, is limited. At best they can influence short and medium term interest rates. As King writes: “But over longer horizons still, such as a decade or more, interest rates are determined by the balance between spending and saving in the world as a whole, and central banks react to these developments when setting short-term official interest rates.”

The word to mark here is “saving”. In the Indian case the household financial savings have fallen over the years. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

If interest rates need to fall over the long-term, the household financial savings number needs to go up. And this can only happen if households are encouraged to save by ensuring that a real rate of return is available on their investments. The real rate of return is essentially the rate of return after adjusting for inflation.  A major reason why the household financial savings have fallen over the years is because of the high inflation that prevailed between 2007 and 2013.

It needs to be mentioned here that while the household financial savings have fallen over the years, the private corporate financial savings (basically retained profits of companies) have gone up over the years. In 2007-2008, the private corporate savings had stood at 8.7% of the GDP. In 2014-2015, they stood at 12.7% of the GDP. So, a fall in household financial savings has more than been made up for, by an increase in corporate financial savings.

The trouble is that corporates do not like to lend long term in the financial system. Most of the private corporate savings are invested in short term bonds and mutual funds which in turn invest in short-term bonds. Hence, corporate savings are typically unavailable for long-term borrowers. They need to depend on household financial savings.

Hence, it is important that household financial savings keep increasing in the years to come. Low interest rates are not possible otherwise.

Also, it needs to be mentioned here that the borrowing by state governments has gone up dramatically over the last few years. In 2007-2008, the state governments borrowed Rs 68,529 crore. This number has since then gone up 3.5 times and in 2014-2015 had stood at Rs 2,38,492 crore. A report in the Mint newspaper expects borrowings by state governments to touch Rs 3,00,000 crore in 2015-2016, a jump of more than one-fourth over the borrowing in 2014-2015.

The borrowing by state governments is expected to remain high in the years to come. This is primarily because of the UDAY scheme that the central government has launched to sort out the mess in the power distribution companies all across the country.

Hence, the demand for money which can be invested over the long-term has gone up over the years and is expected to continue to remain high. In this scenario, the supply of money, through household financial savings needs to improve.

If the number does not improve then the interest rate scenario is unlikely to improve irrespective of the RBI pushing the repo rate down. And the number can only improve if savers get a real rate of return on their investment, encouraging people to save more. This has started to happen only over the last two years.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we to add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%. Hence, Rajan’s formula is clearly at work.

To conclude, it is worth remembering something that George Gilder wrote in Knowledge and Power: “The fastest growing economies in the world have been heavy savers. Saving powerfully diverts consumption preferences from immediate goods to the array of intermediaries funded by savings. Savings prepare the economy for a long future of growth, compensating for the dwindling harvests of consumption in a world of impetuous spending.”

This is something the rate cut crowd needs to understand.

The column originally appeared on Vivek Kaul’s Diary on March 16, 2016

Explained: What Raghuram Rajan Just Did To Make Monetary Policy More Effective

In the last monetary policy statement released by the Reserve Bank of India(RBI) on December 1, 2015, the governor Raghuram Rajan had said: “Since the rate reduction cycle that commenced in January [2015], less than half of the cumulative policy repo rate reduction of 125 basis points [one basis point is one hundredth of a percentage] has been transmitted by banks. The median base lending rate has declined only by 60 basis points.” 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.

What this means is that even though the Rajan led RBI has cut the repo rate by 125 basis points, banks in turn have cut their lending rate by only around 60 basis points on an average. This clearly tells us is that the monetary policy of the RBI (or the process of setting interest rates) has only been half effective.

Why is that the case? A major reason for this lies in the way the banks calculate their base rate or the minimum interest rate that a bank can charge its customers. How is this base rate calculated? As the RBI Draft Guidelines on Transmission of Monetary Policy Rates to Banks’ Lending Rates released earlier this year pointed out: “At present, banks follow different methodologies for computing their Base Rate. While some use the average cost of funds method, some have adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method. It was observed that Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates.”

What does this statement mean? Some banks follow the average cost of funds method to decide on the base rate of their lending. The average cost of funds is the average interest rate that a bank pays on the fixed deposits and other borrowings that it raises. In this scenario if the average cost of funds of the bank is high, a cut in the repo rate is not going to lead to a similar cut in the base rate of the bank.

Hence, even if the RBI cuts the repo rate, the chances of the bank passing on a similar interest rate cut to its prospective borrowers remains low. The trouble here is that banks do go ahead and cut their deposit rates without cutting their lending rates. Hence, they pay a lower rate of interest rate on their deposits but continue to charge a higher rate of interest on their loans. They make more money in the process. Over the last few years, the public sector banks have piled up a lot of bad loans and it has been interest to cut deposit rates without cutting lending rates. It also leads to a situation where the RBI repo rate cut does not percolate through the financial system, making the monetary policy only partially effective.

On the other hand, some banks use the marginal cost of funds to decide on their base rate. The RBI found that banks which used this method where much more faster in cutting interest rates on their loans. Marginal cost of funds is essentially the interest rate that a bank pays on its new deposits as well as other borrowings.

As the RBI Draft Guidelines referred to earlier point out: “The marginal cost should be arrived at by taking into consideration all sources of fund other than equity. Cost of deposits should be calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities. Cost of borrowings should be arrived at using the average rates at which funds were raised in the last one month preceding the date of review. Each of these rates should be weighted by the proportionate balance outstanding on the date of review.”

In a release last week, the RBI said that from April 1, 2016 onwards it wants all banks to follow the marginal cost of funding method to decide on their base rate. This means that if the banks cut their deposit rate in the aftermath of a RBI repo rate cut, they will have to cut their lending rates as well, because their marginal cost of funding will automatically fall. By doing this the RBI has essentially ensured that new borrowers of the bank will have access to lower interest rates automatically once the bank decides to cut its deposit rates.

Further, banks cannot lend below the marginal cost of funds based lending rate. This rate needs to be declared every month on a given date, though during the first year banks have been allowed to declare this rate once every three months.

Also, banks have been asked to declare a marginal cost of funds based lending rate for  overnight loans, one-month, three-months, six-months and one-year loan. The banks have been given the option of publishing the marginal costs of funds based lending rate of maturities longer than one year as well.

What this means is that the banks now have the opportunity of matching their loans with their deposits. Hence, a loan being given out for a period of one year can be given out at the marginal rate of interest that the bank pays on a deposit (or any other borrowing) for a one- year period plus a certain spread over and above it.

As R.K. Bansal, executive director at IDBI Bank Ltd told Mint: “The differentiation based on tenor will be a big positive for banks as now we would be able to price our loans based on the deposits of the corresponding tenor, rather than the older practice of considering 3-6 month deposit rate for computing base rates for all loans.” Following this process banks can now largely avoid the asset-liability mismatch between their loans and their deposits, that they used to get into earlier.

How will this work for new borrowers? They will pay the rate of interest determined by the marginal cost of funds method until the date of the next reset. The reset date has to be one year or lower and has to be a part of the loan contract.

And how will this work for old borrowers i.e. those who have already borrowed from the bank under the old base rate regime? In this case, the borrowers will continue to pay their EMIs as they have been during the past. The banks will keep publishing the base rate as per the old method. In fact, old borrowers have an option of moving “to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.” The RBI has asked the banks not to treat this as a foreclosure of existing facility.

This methodology is expected to help banks to react faster to the repo rate cuts by the RBI by passing on similar interest rate cuts on their lending to new borrowers. In fact, once banks move on to this new way of calculating lending rates, new borrowers are likely to pay a lower rate of interest on their loans, in comparison to what they currently are.

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

The column originally appeared in Swarajya Mag on December 23, 2015

Monetary policy needs to be decided by a committee, and not just the RBI governor



Vivek Kaul

The Reserve Bank of India (RBI) led by Raghuram Rajan presented the third monetary policy statement for the current year, yesterday. In the monetary policy it decided to maintain the repo rate at 7.25%. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the interest rates that banks pay for their deposits and in turn charge on their loans.

The decision of the RBI not to raise interest rates was widely along expected lines and needs no further discussion. Nevertheless, something that RBI governor Raghuram Rajan said during the course of the press conference that followed the monetary policy statement yesterday, is something that needs to be discussed.
Rajan talked about the merits of having a monetary policy committee (MPC) to decide on the monetary policy. The governor currently makes the monetary policy decisions. He is advised by the technical advisory committee which was set up during the time YV Reddy was the governor of the RBI between 2003 and 2008. At the end of the day the technical advisory committee just advises and the final decision lies with the RBI governor.

In the budget speech made in February earlier, this year the finance minister Arun Jaitley had said that: “We will move to amend the RBI Act this year, to provide for a Monetary Policy Committee.”

In the press conference that followed the monetary policy statement Rajan laid out the advantages of having a monetary policy committee decide on the interest rates, instead of just the governor. Rajan basically pointed out three advantages. As he said: “First, a committee can represent different viewpoints and studies show that its decisions are typically better than individuals.”

What does Rajan mean here? As James Surowiecki writes in The Wisdom of Crowds—Why the Many Are Smarter Than the Few: “Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise. An intelligent group, especially when confronted with cognition problems, does not ask its members to modify their positions in order to let the group reach a decision everyone can be happy with.”

So what does the group do? “Instead, it figures out how to use mechanisms—like…intelligent voting systems—to aggregate and produce collective judgements that represent not what any one person in the group thinks but rather, in some sense, what they all think. Paradoxically, the best way for a group to be smart is for each person in it to think and act as independently as possible,” writes Surowiecki.

And this is precisely what Rajan must be expecting from a monetary policy committee making monetary policy decisions rather than just the RBI governor. Rajan further pointed out that: “spreading the responsibility for decision making can reduce the internal and external pressure that falls on an individual.”

This is an interesting point. A RBI governor comes under tremendous pressure from the government as well as businessmen to cut interest rates, when he personally may not believe in doing so. The current finance minister (and even the previous one) has regularly spoken to the media and asked the RBI to cut interest rates.

Businessmen and lobbies representing them do the same thing as well. As Rajan said in a speech in February 2014: “what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.” With a monetary policy committee all the pressure which is currently on the RBI governor can be distributed across the members of the committee.

Also, a monetary policy committee “will ensure broad monetary policy continuity when any single member, including the governor, changes.”
By making these three points, Rajan explained why a monetary policy committee is the way forward for RBI. A section of the media essentially projected this as Rajan falling in line with the government thinking on the issue. And that is totally incorrect. Allow me to explain.

Rajan took over as the RBI governor in September 2013. One of the first reports to be released after he took over was titled Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee). It was released by the RBI in January 2014.

As this report pointed out: “Drawing on international experience, the evolving organizational structure in the context of the specifics of the Indian situation and the views of earlier committees, the Committee is of the view that monetary policy decision-making should be vested in a monetary policy committee.”

Hence, there is no way Rajan could have been against a monetary policy committee. If that were to be the case this paragraph would have never made it to the Urjit Patel committee report. So what made people say that Rajan had fallen in line?

The Urijit Patel committee had recommended that the monetary policy committee should have five members. As the report pointed out: “The Governor of the RBI will be the Chairman of the monetary policy committee, the Deputy Governor in charge of monetary policy will be the Vice Chairman and the Executive Director in charge of monetary policy will be a member. Two other members will be external, to be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas.”

The recently released Indian Financial Code did not agree with this. . Article 256 of the code points out: “The Monetary Policy Committee will comprise – (a) the Reserve Bank Chairperson as its chairperson; (b) one executive member of the Reserve Bank Board nominated by the Re- 20 serve Bank Board; (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and (d) four persons appointed by the Central Government.”

The Indian Financial Code gave the government a majority in the monetary policy committee, with 4 out of seven members being appointed by the government. This was unworkable given that the government has entered into an agreement with the RBI. As per this agreement, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.

This clearly was not possible with government nominees dominating the monetary policy committee. The government always wants lower interest rates. And given that it would have been very difficult for the RBI to control inflation.

There were a lot of negative comments on this attempt by the government to indirectly take over the functioning of the RBI. Not surprisingly the government has now washed its hands of this recommendation.

During the course of the press conference Rajan hinted at the kind of structure he would prefer the monetary policy committee to take. He talked about the former finance minister P Chidambaram’s column in The Indian Express on August 2, 2015.

In this column Chidambaram talked about a six member committee, with three members from the RBI and three members appointed by the government. “In the case of a tie, let the governor have a casting vote. The minutes must be made public. Assuming the three internal members vote alike, the governor needs to persuade at least one external member to agree with him, and on most occasions he will. In situations where all three external members disagree with the three internal members, it will be a brave governor who will vote, every time, in his own favour to break the tie,” wrote Chidambaram.

I am no fan of Chidambaram, but I think for once he makes some sense.

The column was originally published on The Daily Reckoning on August 5, 2015

RBI monetary policy: Interest rates won’t come down unless bad loans are controlled

The third Bi-monthly Monetary Policy Statement for 2015 was released by the Reserve Bank of India (RBI) today (August 4, 2015). As was widely expected, the RBI led by Governor Raghuram Rajan did not cut the repo rate and let it stay at 7.25%. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI did not cut the repo rate because the rate of inflation has been on its way up. As the monetary policy statement pointed out: “Headline consumer price index (CPI) inflation rose for the second successive month in June 2015 to a nine-month high on the back of a broad based increase in upside pressures, belying consensus expectations…Food inflation rose 60 basis points [one basis point is one hundredth of a percentage] over the preceding month, driven by a spike in prices of vegetables, protein items – especially pulses, meat and milk – and spices.”

Food prices are something that the RBI cannot do much about. But prices on the whole have been going up as well. As the monetary policy statement pointed out: “Excluding food and fuel, inflation rose in respect of all subgroups other than housing. The momentum of price increases remained high for education. Inflation pressures increased for personal care and effects and household goods and services sub-groups. Inflation in CPI excluding food, fuel, petrol and diesel has been rising steadily since April.” Non food and fuel inflation will continue to go up as the new (and higher) service tax rate of 14% comes into effect June 2015 onwards. All these reasons led to the RBI keeping the repo rate constant.

More importantly, there is an interesting data point that the RBI monetary policy statement reveals: “Since the first rate cut in January, the median base lending rates of banks has fallen by around 30 basis points, a fraction of the 75 basis points in rate cut so far.”

What this basically means is that even though the RBI has cut the repo rate by 75 basis points, the median interest rate at which banks lend money has fallen by only 30 basis points. At the same time, the deposit rate cuts carried out by banks have almost matched the repo rate cut of 75 basis points that has happened so far.

A report in the Mint newspaper points out: “Large lenders such as State Bank of India (SBI), ICICI Bank Ltd, Punjab National Bank, HDFC Bank Ltd and IDBI Bank Ltd started trimming their deposit rates across various maturity periods since October last year, and reduced them by 75-100 bps[basis points].”

If a bank is cutting its deposit rates much faster than its lending rate, it is obviously looking to increase its profit margins. Why is it doing that? The answer in the current case is the bad loans that have been piling up with the Indian banking sector in general and public sector banks in particular.

Data from the RBI’s Financial Stability Report released in June 2015 shows that the gross non-performing assets of scheduled commercial banks in India stood at 4.6% of their total advances, as on March 31, 2015. The number had stood at 4% as on March 31, 2014.

What is even more worrying is the fact that the total amount of stressed advances have jumped significantly over the last one year. As on March 31, 2014, the stressed advances stood at 9.8% of the total advances. A year later this had jumped to 11.1%. The situation in public sector banks is even worse with stressed advances jumping from 11.7% of advances to 13.5%, between March 2014 and March 2015.

The stressed advances number is arrived at by adding the gross non-performing assets (or bad loans) and restructured loans divided by the total assets held by the scheduled commercial banks. Hence, the borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate. This entails a loss for the bank.

What this means is that for every Rs 100 that public sector banks have given out as a loan Rs 13.5 is in dodgy territory. The borrower has either defaulted or the loan has been restructured.

Hence, it is not surprising that banks have been cutting their deposit rates in line with the fall in the repo rate. But their lending rates have not fallen at the same pace. The idea is to increase the profit margin between the cost of borrowing and the cost of lending. This is to ensure that there is enough leeway to account for the bad loans that have been piling up.

If the banks cut their lending rates at the same pace as their borrowing rates, they will either end up with losses or with falling profit levels. Nobody wants that.
Also, banks on the whole have been using the restructuring route to postpone recognising bad loans as bad loans. What this means is that the bad loans of banks (particularly public sector banks) will keep piling up. And hence, the banks will not cut lending rates in line with future cuts in the repo rate as and when they happen.

As one of the deputy governors of the RBI SS Mundra had pointed out in a recent speech: “There has also been an increase in incidence of suits filed against defaulters and cases of wilful default- an unwillingness to pay, despite an ability to pay. These problems could have their genesis in a failure to exercise the right amount of prudence and due diligence on part of the banker or an ab initio intent of the borrower to defraud the bank.”

Also, because of this the trust needed for a banker-borrower relationship to work well has broken down. As Mundra said during the course of his speech: “Recent spurt in instances of forensic audit being conducted by bankers on their borrowers signifies a breakdown in the implicit trust…The banker-borrower relationship is essentially symbiotic as both need each other. Both have certain expectations from the other and when these don’t get fulfilled on account of a malafide or fraudulent intent on the part of either of them, the relationship gets strained.”

This needs to be set right if a meaningful fall in lending rates has to happen. And at the sound of sounding clichéd, this is easier said than done.

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

The column was originally published on August 4, 2015, on Firstpost