RBI Insists On Monetary Transmission. New Borrowers to Benefit
Dec 02, 2015

Author: PersonalFN Content & Research Team

Here comes the winter chills, bringing along plans of a vacation, perhaps a trip abroad. Frequent flyers are aware that the rate at which you buy U.S. dollars from money exchangers is often higher than what’s offered to you when selling them. It is rare to find a person who is okay with such a blatant discrepancy. The part we usually overlook is that money exchangers work for a business fundamental called “profit”. It’s possible some might be comfortable with this practice provided the difference isn’t offensively high.

The same holds true for banks. Bank deposits for the tenure of 1-3 years are offering you far lower rates these days than what they were offering a year back. However, there isn’t much difference in the lending rates of banks over last one year. And the writing on the wall spells, the RBI is not happy about it. At the Fifth Bi-monthly Monetary Policy review, the RBI reminded banks about passing on the benefits of past rate cuts to borrowers. Going one step ahead, the Central Bank also announced its intent to create a protocol/structure for determining the base rate—a rate that affects cost of your loans and the profits of the banks.

See what RBI had to say about the reluctance of banks in passing on rate cuts

"Since the rate reduction cycle that commenced in January, less than half of the cumulative policy repo rate reduction of 125 bps has been transmitted by banks. The median base lending rate has declined only by 60 bps. The Reserve Bank will shortly finalise the methodology for determining the base rate based on the marginal cost of funds, which all banks will move to."

The RBI has made it clear that the transmission of the benefits of past rate cuts into the economy has been one of the significant pre-conditions for further rate cuts, apart from pace of growth and level of inflation. Naturally, as you guessed by now; policy rates remained unchanged this time round.

So, where do the policy rates stand as of now?

Repo rate under the liquidity adjustment facility (LAF) is still at 6.75 per cent

Cash Reserve Ratio (CRR) of scheduled banks continue at 4.0 per cent of net demand and time liability (NDTL)

The RBI will continue providing liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the L. A. F. repo rate, and liquidity under 14-day term repos, as well as longer term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and

follow through with daily variable rate repos and reverse repos to smoothen liquidity

Status quo of RBI brings forth two things

When it is warranted in times to lower rate cuts, RBI is prepared to shift gears

However, when normalised the RBI prefers taking a pause

We will talk about both the aforesaid factors one by one later in this article.

Let’s see what the background for this policy review was

Weaker global growth

Slowing global trade

Over-supply situation in several primary commodities and industrial materials

Emerging Market Economies (EMEs) continuing to face headwinds from domestic structural constraints, shrinking trade volumes, and depressed commodity prices

Economic growth and inflation staying the course on home turf

This is why RBI kept rates unchanged:

Although the RBI has not reduced policy rates this time, its stance remains accommodative even now. Broadly, the RBI looked at the momentum of inflation and took measures to ensure it remains well contained. RBI had cut rates earlier because the trade-off between incentivising growth and discouraging inflation offered some elbowroom for such an accommodation. The inflation target for January 2016 at 6% was within reach, and the investment cycle was very weak.

Now the RBI anticipates that inflation may rise a bit in December 2015, before it starts leveling out. It is of the view that the Central Government will have to work in close association with state governments to minimise the possible shortfall in the rabi crop. Moreover, the RBI remains concerned with the inflationary pressures in non-food category. The central bank opines that the services sector inflation essentially reflects the shortage of quality education and healthcare. These are supply side constraints and require attention. For inflation in services sector to go down, India requires many more quality education institutions and well equipped hospitals

As far as growth prospects are concerned, RBI retains its forecast of 7.4% for FY 2015-16 with a slight negative bias. Falling in line with expectations, India’s Gross Domestic Product (GDP) grew at 7.4% in the July-September quarter (Q2) of FY 2015-16. By recording a growth rate of 9.3% in Q2 of FY 2015-16, the manufacturing sector recovered well. In Q2 of FY 2014-15, the manufacturing activities had expanded at 7.9%. The Mining sectors witnessed a noticeable recovery, but the Services sectors disappointed.

The RBI remains hopeful about the recovery in the Services sector too. The policy statement reads, "While prospects for a revival in service sector activity have been boosted by optimism on new business, pockets of lacklustre activity such as construction weigh on the overall outlook. The step-up in public capital spending and the easing stance of monetary policy provide the enabling environment for a revival in private investment demand, supported by easing input prices and improving conditions for doing business."

What to expect going forward?

While giving guidance on monetary policy, the RBI says, "The Reserve Bank will follow developments on commodity prices, especially food and oil, even while tracking inflationary expectations and external developments. The implementation of the Pay Commission proposals, and its effect on wages and rents, will also be a factor in the Reserve Bank’s future deliberations, though its direct effect on aggregate demand is likely to be offset by appropriate budgetary tightening as the Government stays on the fiscal consolidation path."

In addition to transmission of past rate cuts, "The on-going clean-up of bank balance sheets will help create room for fresh lending. The Reserve Bank will use the space for further accommodation, when available, while keeping the economy anchored to the projected disinflation path that should take inflation down to 5 per cent by March 2017".

As for the question of the anticipatory impact of Federal Reserve (Fed) normalising interest rates in the U.S., the RBI remains confident about the formidability of Indian markets. It expects the Indian markets to normalise after the initial bout of volatility, this assessment holds true even in case of the Rupee. Therefore, Fed lift off would be a lesser consideration for future monetary policy actions in India.

Clearly, before the next round of rate cuts arrive, your home loans, car loans, and the like may appear more accessible, the balance sheets of banks will be cleaner, and the Government has to have done well on the reform agenda. The bottom-line is, you have to wait longer for the next rate cut, but until then enjoy lower-interest loans. Just avoid going overboard with the cheer of “borrowed” exuberance. Happy Holidays!