RBI policy: Raghuram Rajan holds rate but sends out a strong message to banks to act

For a change, there wasn’t any surprise in the Reserve Bank of India’s (RBI) first bi-monthly policy of fiscal year 2016. The status-quo in the repo rate and cash reserve ratio (CRR) were maintained at 7.5 percent and 4 percent, respectively.
Repo rate is the rate at which banks get money form RBI. CRR is the portion of deposits banks need to keep with the RBI.
But, the key take away from the policy, a non-event otherwise, is the strong message from Raghuram Rajan to the commercial banks on their lack of enthusiasm in passing on the benefits of the RBI rate signals on lower rates to the end-consumer.
Absence of monetary transmission, interestingly, has topped the must-do list of Rajan, when it outlined the preconditions for further rate cuts, even before the potential upside risks of inflation on account of the domestic and This is critical and highlights the central bank’s growing concern on its losing power to prod banks pass on the policy cues through the banking system. Twice in the policy document, this part has found mention.
1) “Transmission of policy rates to lending rates has not taken place so far despite weak credit off take and the front loading of two rate cuts. With little transmission, and the possibility that incoming data will provide more clarity on the balance of risks on inflation, the Reserve Bank will maintain status quo in its monetary policy stance in this review.”
2) “Going forward, the accommodative stance of monetary policy will be maintained, but monetary policy actions will be conditioned by incoming data. First, the Reserve Bank will await the transmission by banks of its front-loaded rate reductions in January and February into their lending rates.”
The central bank’s concerns are evidently stemmed from the stubbornness of banks to lower their lending rates despite a visible slowdown in the credit offtake in the baking system, especially that to industries, one of the reasons that has, in turn, contributed to the anaemic growth in the real economy, especially in the core sectors.
Despite a 50 basis points rate cut from Rajan since January, except three banks, no bank has reduced base rates, or minimum lending rates, even though most banks have slashed their deposit rates.
To be sure, banks have their own reasons for not cutting lending rates. These include the high level of bad loans and corresponding provisioning burden, poor demand from corporates owing to absence of fresh projects and capital constraints.
But, reduction in money flow from banks to the real sector has arguably acted as a hurdle that has prevented a speedy recovery in growth, among other factors. Also, monetary policy of the regulator tend to lose its teeth if the policy actions are not reciprocated by the regulated entities — banks — to make its impact on the ground.
Further, lack of willingness of banks to lower credit costs have evidently contributed to the delayed growth story.
For instance, in February too the core sectors posted a decline in growth to 1.4 percent from 1.8 percent in January, in the backdrop of decline across all major sectors such as natural gas, refinery products, fertilizers and steel.
Ideally, drop in deposit rates should follow decline in lending rates since banks also factor in deposit rates when they calculate their base rates.
But, such a decline hasn’t happened since different banks have been following different methodologies based on their various maturity deposits. The RBI has tried to address this anomaly by prodding banks to move to the methodology based on marginal cost of funds, instead of average cost of funds.
“For monetary transmission to occur, lending rates have to be sensitive to the policy rate… Base Rates based on marginal cost of funds should be more sensitive to changes in the policy rates. In order to improve the efficiency of monetary policy transmission, the Reserve Bank will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their Base Rate,” Rajan has said.
Caution on inflation
On the inflation front, Rajan appeared more cautious this time than in the past while making assessments for the year. The RBI has forecast a 5.8 percent retail inflation by the end of fiscal year 2016 and a fall to 4 percent by August.
But Rajan has admitted that the fall to 4 percent will be more because of a base effect than actual improvement in the price scenario.
Presumably, emergence of recent upside risks to inflation has clearly prompted the RBI to be more vigilant and cautious on further rate cuts. Retail inflation increased to 5.4 percent in February form 5.2 percent in January.
Rajan has given long list of risk factors that could derail the low-inflation story.
This include a less-than-normal monsoon, rise in vegetable and fruit prices due to unseasonal rains, larger-than-anticipated administered price revisions and geo-political developments that could lead to hardening of oil prices.
A clearer picture about the rains would emerge only mid-July, which would give an indication to the movement of vegetable prices, which would play a critical part in charting the inflation course.
As it appears now, the central bank has done with the first rounds of rate cuts and the next rate actions could come only if the two key preconditions are fulfilled.
One, banks showing willingness to pass on the lower rates to the customers and transmit the policy signals to the economy.
Two, monsoons turn out to be good offsetting the impact of the unseasonal rains this year and geopolitical tensions do not aggravate enabling crude prices remain low.
More than the worries related to upside risks on inflation, the central bank, at this stage, appears to be more concerned on the lack of monetary transmission in the banking system.
Chances of big-scale lending rate cuts are limited in the current scenario, where banks are burdened with bad loans and pressure on margins.
On several occasions in the past, the central bank has frankly admitted that it doesn’t have power to make monetary transmission happen in the banking system. Rajan has now stepped up pressure further on banks to follow the suit.