Tuesday, June 11, 2019

More on monetary policy transmission challenge in India

The RBI's rate cut has again raised the issue of monetary policy transmission in India. The same story will repeat - RBI will lower rate and hector banks to pass on by lower lending rates, and the latter will tend to look the other way. 

As Aparna Iyer has written in Livemint, "What good is lowering the price of money if its availability remains doubtful." In fact, far from declining, for a variety of reasons, GSec yields have been climbing unabated. While the central bank has been on the accommodation path, the transmission has remained muted.
Ananth writes about the cost of capital for banks. The prevailing Marginal Cost of Funding based Lending Rate (MCLR) regime is essentially an administered, cost-plus floor rate, and that too one which does not take into account the true cost of capital. As Ananth, says, several cost drivers do not change in the short-run. So he suggests dispensing with administered rates and allowing banks to set their own rates based on their true cost of capital, as reflected in their actual Net Interest Margins (NIMs). In simple terms, the MCLR is neither marginal nor a true cost, and is for all practical purposes a fully administered price. 

Indira Rajaraman writes about the centrality of the GSec yields and also makes the point about how administered savings schemes are a dampener on monetary transmission. She also points to the fact about state governments exiting borrowing from the higher cost National Small Savings Fund (NSSF) and shifting towards the regular financial markets, and the resultant crowding-out effect and the knock-on effect of keeping GSecs high. 

I had blogged earlier about how the nature of the liabilities of Indian banks comes in the way of monetary transmission. Even by the standards of other developing countries, Indian banks are excessively, almost completely dependent on deposits. As a share of liabilities, Indian banks' dependence on deposits is striking even when compared to other developing countries.

This reliance makes them vulnerable on both sides. On the one hand they need to keep deposit rates high to compete with administered savings rates schemes. And on the other hand, given that bulk of deposits are time deposits, this cost of capital is inherently inflexible to accommodate repo rate cuts. Exacerbating the problem, deposit growth rates have remained lower than credit growth rate. In simple terms, as long as Indian banks remain excessively reliant on deposits, their ability to transmit repo rate cuts down to borrowers will be constrained. 

Relaxing the constraints on monetary transmission is a major structural reform, one that involves pulling multiple levers. Dispensing off with administered prices and shifting to market determined rate is easier said than done. It requires dismantling the dual-price market for savings, diversifying the financing sources of banks and lowering the excessive dependence on deposits, and allowing banks to set rates at their true marginal cost of capital. But the short-term ripple effects of any action to address these can be significant and uncertain and can disrupt the market in unanticipated ways. Then there are the political economy constraints. 

A prudent compromise may be required in this regard. For example, on the dismantling of the dual-price market of administered small savings schemes, it will have to be done in a phased manner. A good place to start may be to target these savings schemes to only certain lower categories of employees and with lower upper savings limits. Another choice may be to ring-fence the incremental "subsidy" support from the budget itself, and have that amount transferred directly. 

As an aside, this is an example of how academic research on India, both by Indians and by outsiders, is so skewed towards marginal microeconomic issues. I am not aware of a rigorously researched empirical study that examines the different factors hindering monetary transmission in India. For example, what explains the excessive dependence on deposits for Indian banks, even compared to its developing country peers? An empirical study that examined the contributors and dynamics of monetary policy transmission (or its depression) would have been a good example of truly evidence-based policy making.

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