As we approach the announcement of a monetary policy review, there is the inevitable debate over whether or not the repo rate will be lowered. The call is invariably for RBI to lower it further to spur the economy. The fact that inflation has receded with growth still stagnant provokes this sentiment to be expressed again. Last year, RBI took the stance that the government has to get its house in order and until it did, monetary policy will not make an impact. And in between, India Inc groaned that there was policy paralysis and even if the government did not take any policy decision, the least it could do was not come in the way of the private sector.
Everybody did their bit towards the end of the year. Parliament tried to pass some Bills, with limited success, while others were kept in abeyance. The government actually got the fiscal deficit under control and has actually lowered it to 4.9% in FY13 with a promise to credibly rein it further in FY14. RBI provided support with 100 bps cut in repo rate and 75 bps in CRR. Yet the economy has displayed an unchanged picture. RBI has always maintained that its primary focus was inflation and its expectations; and as long as inflation was high, there was limited scope to lower rates. Yet the RBI response has been quite ambivalent where a similar inflation scenario in the last three policies where the policy rates were lowered by 25 bps each time (a total of 75 bps) and CRR by 25 bps. All the policy notes had one common line of caution that there was limited room for further cuts. But the cuts did surely come in, which makes the market expect one more rate reduction this time. While one can always ask RBI to cut rates further, the questions to ask are whether or not such cuts really work and whether this is a solution for our problems. The view here is that we may be overstating the importance of the repo rate as a tool to spur growth. There are two arguments here. The first is theoretical. RBI has tended to follow the path of the school of Rational Expectations which was popularised by Thomas Sargent and Robert Lucas, who spoke of the shock factor required to make policy effective. Their view was that monetary policy is impotent in case there is perfect information available to economic agents—which means that if the policy stance is clear and the authority sticks to it, then policy is not effective. The rationale is that all economic decisions are taken based on a stated policy framework which leads to an optimal solution. Therefore, the policy move would be ineffective. As a corollary, the only way to make it work is to surprise economic agents. Keeping this somewhere at the back of the mind, RBI has tried to state its objective of inflation and then tried to go against the tenet by lowering rates. However, the market has always expected such a move—supported a lot by the government, which has continuously urged RBI either directly or by innuendo to lower rates. It is not surprising that rate cuts have not really worked. In a lighter manner, the Rational Expectations school says that the only way to make policy work is to fool the market, but when the market is ahead of the curve, the surprise is not really there. The other argument is more practical which RBI has been commenting on. The transmission mechanism is tardy in the banking system. We have seen last year that while RBI got the repo and CRR down, the base rate actually changed by just 30-50 bps even while deposit rates came down by 25-100 bps (1 year). The post Annual Policy base rate has not changed in FY14. Clearly, banks, which are the intermediaries when it comes to passing on the repo benefit, have thought it better not to do so. This has also helped in a limited way to improve their profits given a higher base of deposits relative to credit. The question arises as to why should this be the case? The banking system is free and interest rates are set by individual banks. RBI sets the benchmark but it is left to them to take a call, and the only regulatory part is where the base rate is formula driven. If the cost of funds comes down, the base rate has to come down. Assuming an upper limit of R1 lakh crore being borrowed on a daily basis for the year through the repo window, 1% cut in repo rate over the year translates to R1,000 crore savings for the system. Given that for the system the total interest cost in FY13 was around R4.75 lakh crore and around R80,000 crore in terms of net profit for a set of 42 banks, this additional saving does not really alter the cost for them. Therefore, there is no major gain for them and the repo change is at best a signalling mechanism. Banks evidently look at their own books and the capital requirements as well as NPA and restructured loans books and then take a call on whether they should be lowering rates. Evidently they have not really gone ahead aggressively in this direction, which is justifiable. We evidently need to have the economic climate improve to address these issues. All this means that to project RBI action of interest rates cut as being, what the Bard would have called, the ‘be all and end all’ of our problems is misplaced, and exaggerated. With the initial transmission mechanism being weak between RBI and bank action, and that between banks and industry nebulous—after all investment just does not take place because rates come down by 25 bps, we really need to have all the policy elements work in unison so that we arrive at a concerted solution rather than a piece meal one which is the case today. Investment and growth will take off once we see affirmative policy action along with concrete government expenditure on capital projects and lower interest rates all together. Individual initiatives would at best assuage sentiment for a while and it would be back to the status quo. Curiously, over the last year, the stock market too barely blinked on all the eight occasions when the policy was announced—either with or without a rate cut. A case of the market already factoring in the policy action or inaction?
Everybody did their bit towards the end of the year. Parliament tried to pass some Bills, with limited success, while others were kept in abeyance. The government actually got the fiscal deficit under control and has actually lowered it to 4.9% in FY13 with a promise to credibly rein it further in FY14. RBI provided support with 100 bps cut in repo rate and 75 bps in CRR. Yet the economy has displayed an unchanged picture. RBI has always maintained that its primary focus was inflation and its expectations; and as long as inflation was high, there was limited scope to lower rates. Yet the RBI response has been quite ambivalent where a similar inflation scenario in the last three policies where the policy rates were lowered by 25 bps each time (a total of 75 bps) and CRR by 25 bps. All the policy notes had one common line of caution that there was limited room for further cuts. But the cuts did surely come in, which makes the market expect one more rate reduction this time. While one can always ask RBI to cut rates further, the questions to ask are whether or not such cuts really work and whether this is a solution for our problems. The view here is that we may be overstating the importance of the repo rate as a tool to spur growth. There are two arguments here. The first is theoretical. RBI has tended to follow the path of the school of Rational Expectations which was popularised by Thomas Sargent and Robert Lucas, who spoke of the shock factor required to make policy effective. Their view was that monetary policy is impotent in case there is perfect information available to economic agents—which means that if the policy stance is clear and the authority sticks to it, then policy is not effective. The rationale is that all economic decisions are taken based on a stated policy framework which leads to an optimal solution. Therefore, the policy move would be ineffective. As a corollary, the only way to make it work is to surprise economic agents. Keeping this somewhere at the back of the mind, RBI has tried to state its objective of inflation and then tried to go against the tenet by lowering rates. However, the market has always expected such a move—supported a lot by the government, which has continuously urged RBI either directly or by innuendo to lower rates. It is not surprising that rate cuts have not really worked. In a lighter manner, the Rational Expectations school says that the only way to make policy work is to fool the market, but when the market is ahead of the curve, the surprise is not really there. The other argument is more practical which RBI has been commenting on. The transmission mechanism is tardy in the banking system. We have seen last year that while RBI got the repo and CRR down, the base rate actually changed by just 30-50 bps even while deposit rates came down by 25-100 bps (1 year). The post Annual Policy base rate has not changed in FY14. Clearly, banks, which are the intermediaries when it comes to passing on the repo benefit, have thought it better not to do so. This has also helped in a limited way to improve their profits given a higher base of deposits relative to credit. The question arises as to why should this be the case? The banking system is free and interest rates are set by individual banks. RBI sets the benchmark but it is left to them to take a call, and the only regulatory part is where the base rate is formula driven. If the cost of funds comes down, the base rate has to come down. Assuming an upper limit of R1 lakh crore being borrowed on a daily basis for the year through the repo window, 1% cut in repo rate over the year translates to R1,000 crore savings for the system. Given that for the system the total interest cost in FY13 was around R4.75 lakh crore and around R80,000 crore in terms of net profit for a set of 42 banks, this additional saving does not really alter the cost for them. Therefore, there is no major gain for them and the repo change is at best a signalling mechanism. Banks evidently look at their own books and the capital requirements as well as NPA and restructured loans books and then take a call on whether they should be lowering rates. Evidently they have not really gone ahead aggressively in this direction, which is justifiable. We evidently need to have the economic climate improve to address these issues. All this means that to project RBI action of interest rates cut as being, what the Bard would have called, the ‘be all and end all’ of our problems is misplaced, and exaggerated. With the initial transmission mechanism being weak between RBI and bank action, and that between banks and industry nebulous—after all investment just does not take place because rates come down by 25 bps, we really need to have all the policy elements work in unison so that we arrive at a concerted solution rather than a piece meal one which is the case today. Investment and growth will take off once we see affirmative policy action along with concrete government expenditure on capital projects and lower interest rates all together. Individual initiatives would at best assuage sentiment for a while and it would be back to the status quo. Curiously, over the last year, the stock market too barely blinked on all the eight occasions when the policy was announced—either with or without a rate cut. A case of the market already factoring in the policy action or inaction?
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