By V Srinivasan
The monetary policy easing cycle gained more momentum over the previous quarter with the Reserve Bank of India cutting policy rates by 50 bps, through two inter-meeting moves. While this has brought substantial cheer to various stakeholders, there has been considerable debate on why
‘transmission’ of the policy rate cuts into loan markets has not happened and base rates remain stagnant. Bond markets, of course, had priced in the rate cuts ahead of the event and continue to price in such expectations on an ongoing basis.
To understand why base rates are sticky, let’s first understand why transmission is instantaneous in bond markets. The answer is simple. It all boils down to the cost of funding of that asset. Banks hold trading positions in government bonds in addition to their holdings for SLR purposes. Markets such as RBI repo auctions, CBLO markets and market repos are available for banks to borrow against these bonds held for trading. Lending rates in these markets are anchored to the repo rate and vary depending on prevailing liquidity conditions. Therefore, the cost of funding of the bonds is directly linked to the policy rates. Expectations of future policy rate movements, therefore, directly impact the return on bonds and hence, transmission of policy rate changes is immediate.
For loan assets, deposits are the primary source of funding. Deposit rates are a function of liquidity needs of the overall banking system and are not necessarily correlated with policy rates. For example, we saw banks lowering deposit rates, and some of them even base rates in Q3 FY15 but we saw no such cuts happen in Q4 FY15. This only indicates that liquidity needs of banks were lower compared to normal deposit growth accretion in Q3. On the contrary, banks demanded more liquidity in Q4, as evidenced by higher credit offtake in Q4 (till March 6) as compared to Q3. The LCR norms int roduced in January 2015 also added to liquidity needs of banks. This caused deposit rates to stay elevated and transmission of rate cuts not feasible without erosion of margins.
How do we hasten transmission? First, RBI in its policy statements needs to clearly articulate a liquidity stance that ensures the price of liquidity is synchronised with the easing phase of the cycle. Calibrating liquidity infusions at almost similar levels at all points of the monetary policy cycle, such that the target overnight and short-term rates are maintained close to the prevailing repo rate, makes deposit rates sticky and causes base rates to change at explainable, but unwarranted, lags. Having a liquidity infusion band of 0-2% of NDTL and articulating the extent of infusion depending on monetary policy priorities will help all funding markets price that in appropriately.
Second, it is important for the market to evolve short-term funding products that are anchored to the repo rate. Also, creating securitised instruments with loans as underlying and facilitating shortterm repos in such instruments can improve the pool available for such funding. Third, from a lending perspective, for sectors deemed to be more ‘productive’, nodal institutions can provide refinance at rates linked to repo rate. The price of any commodity is a function of demand and supply and liquidity is no different. System liquidity requirements are volatile while RBI calibrates its supply within a narrow band. This results in rate cuts and lending rate changes not happening in a synchronous manner. For transmission to be effective, underlying liquidity conditions, and thereby its price, need to be modulated factoring in underlying economic conditions. Having funding sources anchored to repo rate would further hasten such transmission. As we approach the new fiscal year, outlook for credit growth in the first quarter is likely to be muted, much like most previous years. This should facilitate ‘transmission’ and downward revision in base rates. However, as credit demand revives on the back of an improving macro environment and runs ahead of deposit growth, transmission of monetary policy rate actions would again become challenging if liquidity conditions are not modulated to smoothen demand-supply dynamics. Let’s take lessons from our stellar management of the rupee and apply it to domestic liquidity for transmission to be timely.
( The author is Executive Director, Corporate Banking, Axis Bank)
