The Reserve Bank of India started its interest rate easing cycle in February 2019, taking cognizance of the headwinds to growth and inflation reading remaining below the RBI’s target of 4%. However, the transmission of the rate-cuts to the end-consumers has remained very gradual and relatively lower than the repo rate revisions. Compared to a cumulative 75 basis points cut in repo rate, there has been only a 10 basis points cut in the median marginal cost of lending rate (MCLR) of the PSU banks for 1-year tenor over the period February-June 2019.
“The weak and asymmetric monetary transmission process has constrained the economic recovery process by impeding the fall in lending rates which could stoke consumption demand”, said Mr Chandrajit Banerjee, Director General, CII. The presence of structural factors such as higher small savings rates in the wake of which banks are unable to cut their deposit rates and therefore lending rates is one of the foremost reasons for this weak transmission process. In addition, the liquidity squeeze seen in the NBFC space post the IL&FS episode last year has also reduced the availability of funds in the financial system, which in turn has hindered the reduction of lending rates.
Going forward, how much rate cuts will stoke and buffer the economy will depend on how effective their transmission is. In this context, we recommend the following measures to improve the efficacy of themonetary transmission process:
1). Government needs to look at the small savings rates and reduce them in line with the market rates. If that does not happen, then the ability of banks to reduce deposit rates will be limited. For example, currently a five-year National Savings Certificate fetches an interest of 8% while Sukhanya Samridhhi scheme offers 8.5%, which is way higher than the 6.80% rate which SBI is offering for deposits above 1-year tenure.
2). Ensure that the liquidity in the banking system remains comfortable as tight liquidity conditions impede reduction in lending rates. This could be done by having a relook at the existing liquidity framework and have a cap on absorption of liquidity by the central bank, for example, the combined limit on liquidity absorption be placed at 1% of NTDL.
3). Cut Cash reserve ratio (CRR) by 50 bps which will release around Rs 60,000 crore into the system. This along with infusing liquidity in the banking system will also reduce the burden on banks’ resources, given the fact that currently the credit-deposit ratio is hovering at a high of 77-78%. Importantly, now that the banks are maintaining 100 per cent liquidity coverage ratio, there is legroom to cut the CRR.
4). Hasten the implementation of RBI’s plan to replace MCLR with an external benchmark as the basis for fixation of interest rates for retail loans by banks. This move is expected to increase transparency and speed of transmission of changes in interest rates in economy. The RBI had announced its intention to introduce this measure in its monetary policy review held in December 2018.