Why linking deposit rate to external benchmark has to be considered: Financial Express 17th Sept 2019

The price of any commodity should ideally be determined in the market. However, often, there is a preconceived notion of how prices should behave. We want stock prices to go up, commodity prices to come down, exchange rate to be steady, and interest rates to come down. These preconceived notions can, then, have a bearing on actual price if there is regulatory power. Let us see how this works.

When it comes to, say, commodity prices, there is the eternal conundrum of whether the farmer should get a higher price, or the consumer should pay a lower price. Today, while the MPC is happy that inflation is down, the income of farmers has been affected, which has affected spending. The reverse of the two can cause political upheaval. But, there is no control over prices as there are myriad players. The same holds for currency. RBI can intervene in the market, and augment supplies to stabilise the rupee, or, conversely, withdraw dollars to ensure there is no further appreciation. But, being a market-determined rate, RBI cannot force the price in any direction by notification, which was the case in the pre-1992 days.

However, when it comes to cost of capital, there has been constant lament that interest rate transmission is not happening, and while the interest rate is no longer controlled (remember the MLR), the options tried were PLR, base rate, and the multiple MCLR system, where the latter two were formula-driven. With the market not quite being amenable, the mandatory link with a benchmark is the final regulatory push that compels banks to fall in line. Curiously, when it comes to interest rates, just like, say, a farm product, there are two sides, too—a saver and a borrower. The die has been cast in favour of the borrower, who should pay less on loans if the interest rate comes down. Ideally, the choice should have been with banks whether or not to link with benchmarks, but after quite singularly bringing in a regulatory formal-based base rate and MCLR, the benchmark is the third on the book shelf of the library that will now rule the market.

The central bank, as the monetary authority, seems to be better-placed when it has regulated banks to use the market benchmark route as it makes monetary policy more effective. RBI had been expressing its angst against transmission, especially since 110 bps cut in rates did not make banks budge much. Now, there is no choice once a benchmark has been selected. But, interestingly, after the last cut by 35 bps, the 10-year Gsec, which is market-driven, has actually remained intransigent in the 6.5% range, and not come down. Hence, if banks had linked retail loans to the 10-year Gsec, even the latest dictate would not have helped as the lending rate would have remained unchanged, as the market, which is driven by other factors, has not moved in accordance with this change. Hence, there are limits to which the benchmark would work.

How about the banks? They are probably riding the horns of a dilemma. Which benchmark to use? Which loans to include besides retail and SME? As deposits are presently not linked with the benchmark concept (except for a specific bank, which has linked savings rate), how do they manage their liabilities? Linking assets to the benchmark, and not the liabilities will strain the bank’s P&L. But, if the deposit rate is also linked to a benchmark in course of time, then customers would be in a quandary as they go in for bank deposits on the assurance of a fixed known return. Now, if it is also made variable, then they would have to bear the volatility in returns, which was not part of their plan. How about the spread over the benchmark, which also has to be anchored for 3 years? If banks want to play safe, they have to choose the benchmark that reacts either the most or least to the repo rate change—Tbill or Gsec, depending on their appetite. The rules are not yet open about whether deposits too can be linked to the same benchmark in phase 2, if, at all, there will be one. This cannot be changed and holds for all customers, and, hence, has to be done with careful thought. Next, the spread over the benchmark should be clear. Here, banks will need to work out their costs, and the possible margins that they would like to maintain, just like what was assumed when working out their MCLRs. This would be the basic lending rate, specified as xxx bps over the benchmark. Wild swings in the benchmark can, however, mean volatility in earnings, especially in a regime of declining interest rates.

How about customers? Intuitively, they would be better off when rates are moving downwards as there would be substantial gains in their EMIs or interest outflows. But, in a rising interest rate scenario, which cannot be ruled out as every economy goes through these phases, there would be challenges in maintaining these outflows. In FY20 so far, the 10-year GSec has moved between 6.45-7.43%, which is almost 100 bps. The 364-day Tbill moved between 5.74%- 6.5%, which is almost 75 bps.

An interesting observation here is that when the financial crisis erupted, which was based on large scale defaults on home loans, it was precisely because the interest rate cycle had turned upwards, and pressurised borrowers, which caused them to default, and leave their homes and keys. While such an occurrence has been looked at today as being a black swan incident as it looks very unlikely that there can be thousands of home owners defaulting at the same time, it is a possibility that cannot be ruled out as interest rates on home loans, which is what is being driven by the government, is going to be variable.

The new interest rate setting model, based on benchmarks, will be a new experience. Hopefully, customers should continue to have a choice of going in for a fixed or floating rate, as it can affect them adversely when the cycle moves up, just as they benefit when it comes down. Also, the critical part of linking the deposits to the external benchmark has to be taken as this one-sided-linkage creates challenges on their interest spreads. As retail and SMEs also tend to move in large numbers, when it comes to response to lower interest rates, and the new dispensation comes in the downward movement regime, the response in upward movements would require close monitoring. From the point of view of monetary policy, this will go down as the final salvo being fired.

Pivot to the future | How firms should evolve to keep up with changing trends: Financial Express 8th Sept 2019

In 2010 Pepsi realised that what worked so well for them for decades would not do so in future, what with the anti-cola lobby gaining ascendency. Health and environment activists were on a winning spree with proven theories on the ill effects of consuming colas. Indra Nooyi got into the act to change strategic direction to keep the company growing. There was now a threefold strategy put into action which had products that were ‘fun for you’, ‘better for you’ and ‘good for you’. Therefore, the restructuring was in place to ensure that continuity was maintained and that the company will continue to grow. Companies in the retail space such as Sears, on the other hand, were not able to see the blow coming as technology pervaded the world and malls went out of fashion and online shopping caught on, with the likes of Amazon sweeping traditional retailers out of business. Companies hence have differing ability to foresee such threats and take necessary action. Some survive and continue to grow while others perish.

Pivot to the Future is another book that tells firms how they should be on alert to smell major changes taking place that have to be leveraged or countered depending on the situation. Abbosh, Nunes and Downes in this book lay down firm rules about what should be done and point towards the pitfalls on the way. Such templates are very common where experts in the academic field or practitioners draw on their experiences to draw up such rule books. These presentations on how to plan for the future are as common as conjecturing what the world will or should look like in all books with titles that are suffixed with 2.0 or 3.0.

We all know that technology has been a major disruption, which can come in different forms right from the way in which we do business like retailing, to the use of higher forms like AI to do our work. Similarly, we know that environment is a major challenge and governments and regulators will be doing their best to put curbs. Electric vehicles will be the future at some point of time, which will lead to obsolescence of several related traditional industries. Yet we observe that what these authors see as logical, which the reader will agree with, is never prophesied by several very large companies that spend a lot of time on strategic planning.

The authors build their theory on the foundations of what they call ‘trapped values’, which provide the pivot to steer away from these pitfalls. Trapped value according to them resides in four buckets. The first is society where there is failure to engage profitably to solve societal issues, such as the need to deal with the environment. The second is with consumers where value gets trapped in underused private assets such as vacant homes in popular tourist areas that can be rented. The third is industry where value is trapped by lack of cooperation and investment in shared infrastructure such as charging stations for EVs. Last is enterprise, where value gets trapped in limited use of digital technologies to transform business.

The authors also drive home some basic characteristics that go with successful organisations. The first is courage to accept that the present offerings are not going to be that appealing in future and there is need to embrace technology and bring about innovation in business tools and management approaches. The second is to be patient for success, as no start-up or enterprise clicks from the first year. The third is to be generous in the sense that as an enterprise succeeds, various customers and partners also tend to benefit probably even more as they save on the cost of experimentation. Fourth, enterprise needs to be realistic as some investments don’t work out and the cost in terms of time, effort and money has to be accepted.

For pivoting the organisation, the authors also talk of anchors that go beyond innovation, which are interesting. These are financial pivots such as fixed assets followed by working capital and human capital. The telecom industry is a good example, which explains how much fixed assets are appropriate and at what point it becomes a liability. Consumer-oriented firms have to take a call on working capital inventory to match the changing tastes of consumers. Finally, human capital is another factor today that becomes a pivot as skill sets become less relevant with the advent of technology.

The authors also talk of a ‘people pivot’ which involves mindsets of both leaders and employees. Often leaders are good at operations but not at thinking far. In fact, most stories of failure can be traced to leaders who could not see the change coming. Employees will always be diverse and getting the right future set is a challenge as skill sets vary. Therefore, their response to these changes is important so that the morale of the employees is always high, which is achieved through training and making them more flexible in mindset.

Will bank mergers make a difference? Financial Express 7th Sept 2019

The decision to merge disparate PSBs into a set of 12 banks is quite a big step, and adds a new chapter and outlook to the concept of public sector banking. We had the Indradhanush Scheme in the earlier episode of banking reforms, in 2015, and after the successful merger of SBI with its associates, and that of Bank of Baroda with Dena Bank and Vijaya Bank, the government is more certain about the future path. From an economist’s point of view, what does this mean?

Merger of PSBs is often seen as a compromise as it does not change the way in which banking is conducted, and is analogous to merging various state departments. Ideologically, it is clear that ownership remains with the government; there would be no let-go on this aspect of banking. The staff count does not go down, which is a positive compared with mergers of private banks, where several jobs, especially at the senior level, are dispensed with. There are savings, in case branches are closed, and staff transferred, which is painful, but preserves tenure of staff. Besides, when it comes to PSBs, officers are used to transfers. But, the latest presentation is silent on how various senior positions have been re-allocated in the last two episodes of mergers as there cannot be multiple risk, credit, treasury, operations, IT, etc, heads. Clearly, several staff may have lost their seniority. But, this can be rationalised as being necessary for the larger good. What is the larger good?

It is interesting that PSBs are still talked of as instruments used for meeting larger political goals. For instance, for MUDRA loans to SMEs targets have been set for PSB, but not for private banks. The one time settlement (OTS) scheme for SMEs spoke of holds for PSBs only; it is not obligatory for private banks. Also, when there is an assurance that some PSBs have agreed to link their lending rates to the repo rate, it is implicit that there are orders from above. Therefore, even today, PSBs are not as free as their private counterparts when it comes to taking credit decisions at the macro level. Even the Jan Dhan exercise was driven by PSBs, as are loan waivers.

As the owner of these banks, the government has a right to decide these policies, but, it also means that the high command approach still holds, and will continue to do so for the merged banks. Hence, while the concept of the so-called ‘phone banking’, which can be catastrophic, has been abolished; banks still have to adhere to these guiding orders, and will not be independent like their private counterparts.

A lot of changes will be seen in the governance structures, such as appointments to the Board, remuneration to Board members, review by the Board of all designations above general manager, etc. But, given that Board members would still be driven by the overriding instructions from above, it may not mean much, if the basic pillars of business guidance are fixed.

Also, it has been reiterated that the chief risk officer position would be mandatory, and there would be outside recruitment at market pay. Does this mean that PSBs with a total officer staff of over 400,000 do not have the talent to fix 12 posts in these banks? There is already quite a bit of ill-feeling on lateral recruitment of some tenure-driven posts in PSBs; this announcement can be more demoralising. Ideally, bringing in a performance-linked bonus for high performers would have the sent right signals in the market, and raised morale. This is definitely required to enthuse the staff of the merged banks, especially since there will be substantial disruption on account of the mergers.
Curiously, the new mosaic talks of willingness to pay non-official directors a higher sitting fee, but not the existing staff, who have built these banks over the years. This is something which should be addressed in course of time, and would also appeal to the Unions.

Now, coming to the idea of a merger, it must be realised that the overall balance sheet size cannot change with these mergers as there is still a fixed set of assets and liabilities. Statistically, ratios look better for the merged entity as it adds profits of strong banks to losses of weak banks. But, there is no new profit being generated anywhere. In fact, statistically, the ratios of NPA and capital adequacy of merged banks tend to be higher or lower than individual components of the entity.

Based on the dictum of one of the large business consultants in 1999-2000, we are following a model where the banking system has global, national, and more niche specific banks. The approach can be questioned in this modern age, where the focus is more on inclusive banking, with more sophistication in financial markets. Are we really saying that large banks created will be able to be in the USA what, say, Citi Bank is in India? There are regulatory barriers everywhere, and the approach, so far, has been to close down unprofitable foreign branches. In that case, what exactly are we talking of?

It has been argued that large banks with bigger capital can take larger exposures. But, is that what we want? RBI’s large exposure norms clearly want banks to lower their exposures to large borrowers in order to reduce concentration, and are being prodded to borrow from the bond market. In that case, this cannot be a goal for PSBs. Merging for the sake of merging banks, without changing the operational structures, may not necessarily lead to an optimal solution. True, any rationalisation in costs, like closing of branches or ATMs, can help the profit-and-loss account. But, the same could have been worked out between PSBs without such mergers, too, with, say, PNB not retaining a branch where OBC has one.

The fear, probably, with such large PSBs is that crises tend to get magnified. This has been witnessed in some banks at different points of time, but, being a relatively rare occurrence, is less of an issue. Alternatively, there should ideally be no pushing of programmes by the government on lending, or even schemes like Jan Dhan, so that banks take independent decisions, based on commercial logic. At the extreme limit, the push for SME lending, or affordable housing can germinate the seeds of a crisis (which may look unlikely today).

The timing of these mergers is also curious; almost all PSBs are struggling to come to terms with the existing NPA crisis. While NPA ratios have declined, at close to 10%, they are still very high. A large number of cases are pending with the IBC, which, in turn, quite expectedly, appears to have lost steam, with the realisation rates now coming down, after the initial success. Now, all would be working hard on these mergers, which take time to put together.
The contrarian may just argue, quite rightly, too, that there was really no immediate need of such big bang mergers—they could have been planned over a period of time to eschew disruption.

Our lending rates are actually quite reasonable: Business Line 6th Sept 2019

There seems to be a high degree of concerted efforts to force banks to lower their lending rates in response to the 110 bps cut in the repo rate. The FM’s assurance that banks have agreed to link their lending rates to the repo rate is testimony to the power of the nudge. But does it make economic sense?

Determining cost

The base rate and the MCLR concepts are well-defined, and hence one can get the benchmark number based on the formula. But how should one look at the basic cost of capital, i.e., the interest rate? The interest rate is the price for capital based on the demand and supply of funds; with the latter being higher today, there is reason for the price to come down. But this is theory.

In practice, there are compulsions from the regulator as well as shareholders, and the final basic cost must reflect these realities. Let us look at different ways of arriving at this number.

In India, if banks have to lend ₹100 they have to raise around ₹130, as 4 per cent of the NDTL has to be kept aside as CRR and 18.75 per cent as SLR. The cost of funds for banks in 2017-18, based on RBI data, was 5.1 per cent, which can be applied to ₹104. For the balance, the difference between return on advances and investments can be applied, as this is the cost of regulation. This was 1.3 per cent, and hence the cost of SLR would be 0.34 per cent. For commercial institutions, the return on net worth of at least 10 per cent can be assumed.

Lastly, a provision for NPAs is also required. Assuming a fair NPA ratio of 5 per cent (although it is 10 per cent today), for the ₹5 of potential NPA on lending of ₹100, a provision norm of 50 per cent would mean a cost of 2.5 per cent. The total cost is shown in the given chart.

This marginal cost can be fine-tuned based on the actual cost for a bank.

Another way of calculating the ideal marginal cost is to take hints from the market. As lending is to the non-government sector, the accompanying pricing by the market gives insights. Here, for example, one can look at how various rates move relative to the repo rate changes. Presently, with the repo rate at 5.4 per cent, the immediate reaction should be seen on GSec yields. The present range of GSec yields are in the region of 6.5-6.6 per cent for the 10-year benchmark used to reckon corporate bond yields. The spread for AAA bonds, which is the best quality of the security that can be raised, is in the region of 100-120 bps. This goes up to 225 bps for AA bonds and 300 bps for A-rated bonds. The latter two can be ignored, and if the spread of AAA is added to the GSec yield, the cost would be 7.5-7.8 per cent.

To this should be added the cost of intermediation, which is what distinguishes the market from the FIs. RBI data for 2017-18 shows this to be 1.85 per cent and hence the overall cost of funds would be 9.35-9.65 per cent.

Now, the present range for MCLR is 7.5-8.4 per cent which is significantly lower than the costs arrived at in these two alternatives, which give similar ranges of 9.35 per cent. There is hence in a way some convergence between the market way of pricing debt and the costing from the point of view of banks.

This really begs the question of how much more banks should be lowering their rates while also maintaining their viability. The critical part to this exercise is that the market is the best judge of the cost of capital, and if GSec yields react in a particular manner, then the bond spreads provide an indication of what the disintermediated market throws up as the cost of borrowing.

Lowering rates

There are hence two aspects here. The first is on how the ‘risk-free price’ moves, which can be driven by other factors besides the repo rate, as is the case today. The second is the risk perception of the top layer of borrowers which is indicated in the spread for AAA companies.

For the realistic cost to come down, both these elements should decrease. If they do not come down, then nudging banks to lower their lending rates may go against the economics of interest rates.

Why transfer from RBI reserves to the Centre is a non-issue: Financial Express Sept 4 2019

Central banking is probably one of the more profitable businesses. The combined Federal Reserve income and expenditure statement shows a net profit margin (surplus before transfer to treasury to total income) of 55% in 2018. In the case of the Bank of England, the banking department had a margin of 16.4% in FY18, while for the issue department it was 54.3%. In 2018, the ECB had a margin of 58.6%, which is in line with the Fed. In case of RBI, for FY19, it has been a very impressive 91%, which wouldn’t change much even if the special provision of `526 billion is excluded.

Central banking is quite a singular business because the organisation has to exist to ensure that currency is in the system, besides conducting other conventional functions like monetary policy, exchange rate management and public debt management. In a way, there are no ‘real’ financial statements like the ones for a commercial entity, where a sale is associated with cost of production or an asset, like a loan associated with a deposit that is created. For a central bank, money is created by the proverbial stroke of the pen, and the rest of the activities are managed accordingly in a seamless manner. At the end of the day, there is a surplus on account of these transactions, and the resulting amount is transferred to the government. But, how does this money get generated?

RBI earned `583 billion as interest in FY19 on holding of government securities. The stock of government securities held was around `9.9 lakh crore, and had increased by `3.6 lakh crore on a point to point basis during the year. These securities yield an interest payment to the holder, which is RBI. Interestingly, RBI had conducted a marathon size of OMOs of `3 lakh crore last year to ensure that liquidity was available to the system.

Add to this the LAF, which supported the virtual continuous deficit to the extent of 1% of NDTL of the banking system in the region of `1-1.5 lakh crore. By buying such securities, the central bank earned interest paid by the government. At even, say, 7% interest rate, the earnings are substantial.

If one follows the trail of these perennial liquidity scarcity episodes, the path is quite fascinating. The government has to borrow to meet its fiscal commitments, and last year, had a gross borrowing programme of `5.71 lakh crore. These are subscribed mostly by banks, which then ran into a problem of liquidity as growth in deposits was tardy. RBI stepped in and provided liquidity on a daily basis through the LAF window, and on a permanent basis through the OMOs. With the latter supporting 53% of the gross borrowing programme, the deficit was monetised adequately.

The government pays interest on these bonds, which adds to the central bank’s profits, and is finally paid back to it as a transfer which supports the fiscal numbers. This ‘circle of money’ is the curious aspect of central banking, where there is a very impactful relationship between monetary policy and the Budget. Ironically, if the bonds are subscribed to by banks and there is no liquidity issue, RBI does not come into the picture, and the interest accrues to them instead of flowing back to the government.

This is not specific to RBI, but to all central banks. In case of quantitative easing, the Fed or ECB bought paper from banks and, hence, received income which would have otherwise gone to the original holders. Such paper was monetised by providing liquidity to the banks and, hence, was a win-win situation, where the system got funding while the central bank earned revenue.

The cost was the liquidity, which is reserve money created by central banks constantly and, hence, does not matter unless it leads to inflation. When economic conditions are depressed, as is the case in India, this possibility does not arise and, hence, the impact is neutral.

There is another `290 billion which comes as forex gains for RBI. Here, too, the central bank has an inherent advantage when there are problems in the currency market. The central bank intervenes in the forex market when there is excess volatility and the rupee depreciates sharply. All the forex reserves reside with the central banks, and can be used during such contingencies. Intervention is by selling dollars in the market to enhance supplies and bring about equilibrium. Other ‘speaking’ operations are pursued by RBI to curb speculative activity in the market.

In FY19, RBI sold $15.4 billion in the market, which resulted in a capital gain. Intuitively, the rupee tends to depreciate over time, and as the sale takes place when the value is declining further, any sale will give a profit to RBI. Therefore, once again, a situation of forex crisis bodes well for central bank revenues and, ultimately, for the government, which also gains when the surpluses are transferred.

This is over and above the interest it earns by investing the forex reserved in securities outside the country. The earnings were `458 billion on holdings of `27,852 billion of forex assets in securities or deposits. In fact, when RBI bought dollars from banks to provide liquidity, it automatically added to its reserves. Here, too, the trail is predictable. As our balance of payments improves and dollars accrue to the system, they move to the central bank which monetises the same through the power given to it. Now, these reserves are invested in overseas assets and earn an income.

The major bonus was `526 billion, which comes under write-back of provisions no longer required. The committee that worked out the complicated route to using RBI’s excess reserves came up with an ideal formula, based on prudent global practices. While the well-executed formula talks of basic tenets to be adhered to, the broader question, which is posed in some quarters, is whether or not there can ever be a risk to a central bank, which has unlimited access to ‘reserve money’ and runs what can be called, at the limit, a notional balance sheet?

This point may be pertinent; while depletion of forex reserves can drive a central bank down, the same never can happen for domestic currency, which can be issued, at will, by the central bank. A fair question is what exactly a contingency reserve is meant for, especially as the balance sheet has real assets—securities, bank deposits, forex—which are mapped notionally to liabilities, where even the ‘real component’ of currency actually has no limits for a central bank.

The argument is similar to whether a government can ever default on its domestic loans for want of money. Does this then mean that, practically speaking, this debate over transfer of reserves is a non-issue?

Difficult to sync lending rates with repo rate: Financial Express 27th Aug 2019

The 10-years GSec has moved down by 110 bps between August 10, 2018, and August 9, 2019, 364-days Tbill by 143 bps, 91-days Tbill by 124 bps, and call rate by 90 bps.

The midpoint rates have moved from 6.625% to 6.825%. The mid-point savings bank rate has, on the other hand, come down from 3.75% to 3.375% in this period.

It is now almost axiomatic that whenever the MPC convenes, there will be a rate cut in case CPI inflation is reigning at less than 4% and the risk factors are minimal. At present, oil price is down, and there is little possibility of a spike as every time supply comes down from the cartel, the US tends to provide the required substitution. Besides, the world is moving towards less oil consumption. The monsoon has turned normal and, while there can be marginal shortfalls, it is unlikely that prices will shoot up. Yes, prices of vegetables can create panic at times due to the recent flooding in several parts, but that would be temporary in nature.

The important question is whether or not we have been relying too much on monetary policy for growth, and lost the plot along the line. The economy has been stagnating as several sectors show declining growth and job losses. The government has chosen to stick to fiscal prudence and sought to revive animal spirits through some ‘talk’. The recent measures announced by the FM are more in the nature of addressing pain points of industry, like auto or SME, or banks and not any additional fiscal outlays. The withdrawal of the surcharge on tax to be paid by FPIs is probably the only one which has fiscal implications. But, plain talk, not backed by financial resources, has not worked in the last three years. That is the difference between ‘RBI talk’ and ‘government talk’. ‘RBI talk’, also sometimes loosely called ‘open mouth operations’, has worked to cool the currency and, at times, interest rates that are market determined. But, when it comes to the government, industry does not seem to be convinced and is waiting for a ‘delta’ to flow in the form of additional expenditure announcements. This is not happening.

Captains of industry have been asking for rate cuts more out of habit, and RBI and MPC have been obliging with alacrity. When it was 25 bps, they argued that it was anaemic and something more potent was required. Last time, it was 35 bps and, hence, industry should be happy. RBI and the government have both been haranguing banks to lower rates, and the famous epigram of all discussions in the media is that the ‘transmission is rigid’. Let us see how these numbers have moved in the last one year or so.

The repo rate has come down by 110 bps in the last year, ending August 9, 2019. The first point of action has to be the deposit rate as it feeds into the MCLR, which becomes the indicative rate for borrowers. The one year deposit rate has moved from 6.25-7% on August 10, 2018 to 6.35-7.3% on August 9, 2019. The midpoint rates have moved from 6.625% to 6.825%. The mid-point savings bank rate has, on the other hand, come down from 3.75% to 3.375% in this period. The weighted average rate on term deposits has gone up from 6.72% in June 2018 to 6.84% in June 2019. Quite clearly, banks are cautious here as lowering deposit rates in general will affect the supply of funds and, given that deposits are 76-78% of total liabilities, lower repo rates do not necessarily translate to lower deposit rates.
Let us look at the lending side. The MCLR has moved up from an average of 7.9-8.05% to 7.9-8.4%—a mid-point increase from 7.975% to 8.15%—at a time when the repo rate has been lowered. The WALR on new loans has moved from 9.45% to 9.68% (June to June), while that on outstanding loans has increased from 10.26% to 10.43%.

The question is why lending rates are not coming down, when policy rate has fallen sharply in the last year? First, MCLR is a function of the deposit rates and, if the latter does not come down or increases, it does not really point to lower lending rates. Second, even if the MCLR comes down, the effective rate for customers may not come down if credit risk perception is higher. And, at times when the economy is in an acknowledged state of slowdown, with corporate sales growing at an anaemic rate of 5% in the first quarter, it would be incorrect not to price in this risk when lending to most clients. That is why the WALR has gone up during this period. Therefore, the issue of transmission must be left to banks, rather than being decreed from above, as interest rate is the price for capital which should ideally be the reflection of demand and supply. Supply is restricted by deposits growth while demand is screened by banks, based on quality, where credit risk matters. On the demand side, it should be realised that it has not kept pace as there is still surplus capacity with industry. Also, private sector investment in infrastructure is still limited and, hence, comes in the way of demand for funds.

The market reaction to interest rates has, however, been amazingly proactive. The 10-years GSec has moved down by 110 bps between August 10, 2018, and August 9, 2019, 364-days Tbill by 143 bps, 91-days Tbill by 124 bps, and call rate by 90 bps. This means that the government bond market reacts well, and those borrowing here tend to gain the most. Here, the biggest beneficiary has been the government, which has a gross borrowing programme of `7 lakh crore this year and can lower costs by over 100 bps and save Rs 700 crore. Also, the gross Tbill issuance for the year would be above `10 lakh crore, getting in a benefit of Rs 1,000 crore in interest payments on an annualised basis relative to last year.

How about the corporate bond market? Here, interestingly, the corporate bond spreads over GSecs has moved upwards quite perceptibly. It was by 37 bps for AAA bonds, 71 bps for A rated bonds and 51 bps for BBB rated bonds during this one year period. Clearly, the risk perception on commercial lending has increased and, hence, while GSec rates have moved downwards, the market has priced corporate bonds higher. And, if the market reaction is testimony of the final interest rate, credit has actually been priced higher.

The conclusion is quite revealing. Lowering of rates by RBI definitely helps the government lower the cost of borrowing, which can be up to Rs 2,000 crore a year, depending on the tenure of issuance. However, when it comes to commercial credit, banks cannot, and do not, respond the way the central bank would like as they have to also consider the growth in deposits, which is mainstay for them and, hence, transmission will be slow, depending on their requirements. Also, credit risk has to be priced appropriately; and ex poste numbers do reflect the perception. At a broader level, it raises the issue of whether we should at all expect banks to lower their deposit and lending rates when the RBI lowers the repo rate, especially when the market does not support such actions as seen in the bond spreads.

RBI policy: More rate cuts likely ahead as MPC prefers growth to inflation: Business Standard 7th Aug 2019

The credit policy this time is unique as for the first time there is a 35 basis point (bps) cut in the repo rate. This is a kind of compromise between the expected 25 bps cut and the more aggressive 50 bps which the market wanted. This has not had an immediate impact on G-Sec yields with the 10-year bond still at 6.31-6.33. The hope is that the transmission is faster to the lending rates, which would soften and help industry grow.

The previous rate cuts of 75 bps with accommodative stance have not quite worked to push up investment, and hence it would be interesting to see if this fourth cut changes the track. For sure some of the lending rates would come down, which may benefit home buyers or companies with debt, but for investment to pick-up, demand conditions need to change and turn positive. From a monetary standpoint, this had to be done to support growth as inflation is largely under control with favourable monsoon, crude prices and declining core inflation.

This entire chain of rate cuts and GDP growth brings to the fore also the effectiveness of monetary policy to stimulate growth. The process is long. First, the deposit rates need to come down, marginal cost of lending rate (MCLR) have to come down, bank spreads remain stable above MCLR, credit risk perception remain positive and more importantly, demand has to be robust for funding. This is why the link between interest rates and growth had been feeble. While models show that it works with lags of four – six quarters, there could be several developments that come in the way of growth.

The MPC has also brought down the projection of GDP growth of 6.9 per cent from 7 per cent, which is not significant but definitely does affect sentiment as any number less than 7 per cent is interpreted as weakness considering that growth was 6.8 per cent last year. Moreover, for the first half, growth has been placed at 5.8-6.6 per cent. Growth in Q1 will be particularly low and is expected at less than 6 per cent by the market given the economic indicators available so far. There is, hence, a bet that the economy accelerates to 7.3-7.5 per cent in H2, which will mean a very favourable festival cum post-harvest season.

Going forward, it does look like that the MPC will be focusing more on growth than inflation that has been taken to be within the comfort zone for the entire year. The interesting conjecture that has to be made is whether there will be more cuts in this situation.

Growth will be lower this year, and hence, with the number being less than 6.6 per cent for H1, the question is will there be another rate cut before the second half begins? This does appear to be the case and a repo rate of 5.15 per cent in October looks more or less given and in case such weak tendencies continue, the policy rate can go at less than 5 per cent too during the year.

The core sector data which came for June at 0.2 per cent was dismal and indicates that industrial growth will be less than 1 per cent. This has probably been kept in mind when taking a rate cut call this time as inflation appears to be well within the 4 per cent band and presently is hovering at just above 3 per cent with a favourable outlook. The rupee concerns are still there and it looks more like that the external factors will drive the rupee lower towards the Rs 70.5-71/$ mark in the coming months – though a lot depends on how the FPI flows behave.