Minutes from the February’s rate review validate market expectations. The Reserve Bank of India’s monetary policy committee is on course to cut rates for a second consecutive time this week, retaining the distinction of being the first regional central bank this year to return to an easing cycle.
Justification to cut rates is clear. Among Asian peers, India witnessed the sharpest correction in inflation (January 2019 vs 2018 average) and has the most comfortable real rates buffer.
There are incipient risks to the inflation trajectory from receding base effects, food prices that could mean revert after recent disinflation, a cobweb phenomenon in the food production cycle, and the expansionary budget. Nonetheless, evolving trends suggest FY20 will mark the third consecutive year of sub or near 4% inflation.
With governor Shaktikanta Das clarifying that higher weightage will be on headline inflation, rather than the stickier core numbers, the Street is catching up with a decline in implied rates. Add to this, growth also needs a hand as economic activity is showing signs of strain, owing to weakness in consumption proxies along with sectors previously served by non-banks. Odds are rising of another cut in third quarter of fiscal 2020 before a pause.
For lower rates to matter to growth, one returns to the transmission debate. An inefficient transmission mechanism limits the scope of spurring credit growth, which in turn fails to boost growth/spending trends. RBI had estimated in the past that any impact on lending rates shows with a lag of two to four quarters. In December, RBI proposed banks to link their floating rate loans to external benchmarks, such as the repo rate, 91-day T-bill rate and 182-day T-bill, amongst others.
Spreads were to be left to the commercial judgement of banks, with regular assessment and resetting of rates. In February, RBI clarified that this proposal was under review, and passage of the 1 April deadline for guidelines suggest this exercise will not happen in a hurry. Making loan rates more attuned to changes in benchmark/market rates is not without pitfalls, particularly in instances when the rate direction reverses.
Showing a conciliatory hand, State Bank of India set the (transmission) ball rolling last month, as certain segments of loans were pegged to the repo rate. More banks were expected to follow suit, but the scale of adherence will be guided by their respective balance sheet strength, deposits size, and anticipated duration of the rate-cutting cycle. There are a few legacy issues that institutions are dealing with, the foremost being the state of the banks’ balance sheets. An RBI paper established that banks’ gross NPA and stressed assets ratios impact banks’ net interest margins, prodding them to build in a margin over their lending rates.
Concurrently, a downward adjustment in rates starts with the deposit rates, however in this cycle, deposit growth has lagged a rebound in loans, keeping the loan to deposit ratio sticky at highs. On the structural end, household saving rates have also been on the decline, pulling overall savings lower.
This stickiness on the liability side of the banks’ balance sheet lowers the impetus for banks to pass benefits on to assets (i.e. loans), making base rates sticky.
Add to this, the maturity profile of deposits is skewed towards medium to long-term deposits. Lastly, competition from alternative deposit instruments, including small saving schemes, post office savings, mutual funds (financial investments) etc., has risen, with few accompanied tax benefits.
Besides banks, policy transmission through bond markets also matters. Short-tenor bonds have gained from RBI’s accommodative bias, but the belly-longer tenor papers have underperformed. Passthrough to the latter has been overridden by other concerns; lacklustre demand until recent weeks when FPIs made a tentative return, domestic liquidity drain, and a sizeable government borrowing program for FY20. Longer-tenor yields are likely to find a floor as markets seek clarity on the frequency of similar swap auctions, likelihood of bond buybacks in FY20.
Liquidity conditions are an important ingredient in determining the extent of transmission. Banking system liquidity has been near neutral-to-deficit since 4Q18, despite RBI’s support. Considering concurrent leakages in the system, the central bank will be expected to take a proactive approach though more term and variable repos, open market operations and, if required, durable liquidity infusion through reserve ratio cuts. Introduction of the recent swap measure is encouraging, albeit higher frequency and bigger quantum are needed to materially influence liquidity.
Radhika Rao is economist and senior vice-president at DBS Bank, Singapore.