RBI's rate cut won't mean lower lending rates

The Reserve Bank of India (RBI) surprised analysts earlier this month by opting for a 25 basis points cut in the policy rate. Three points about the policy change are worth noting. First, the RBI’s action is in line with the stances of central banks elsewhere. Global growth prospects are perceived to have weakened. As a result, central banks in the US, the UK and Australia have signalled a willingness to ease monetary policy. Indeed, governments in the US and Europe have moved towards a combination of fiscal as well as monetary loosening.

In his statement, the RBI governor indicated that slowing global growth was an important consideration underlying the decision to cut the policy rate. True, the RBI does not see growth in India slowing down, unlike in advanced economies and in some emerging economies. It expects India’s growth rate to rise from 7.2 per cent in 2018-19 to 7.4 per cent in 2019-20. The case for a rate cut rests on the gap with respect to output potential being wider than projected earlier.

Second, it’s becoming clear that the perception of upside risks to inflation in the RBI’s earlier policy statements has turned out to be misplaced. Some of the reluctance to cut rates arose from the fact that core inflation — that is, headline inflation minus food and fuel price inflation — was above 5 per cent. Inflation data for January 2019 suggests a trending down of core inflation. There is every likelihood now that core inflation will stay below 5 per cent and headline inflation below 4 per cent in the coming year. 

Third, the votes cast in the Monetary Policy Committee (MPC). When the MPC was constituted, it was assumed that the two internal members of the RBI would not go against the RBI governor. If the three outsiders were to differ from the three RBI members, there would be a tie. Hence, the RBI governor was given the casting vote. It is striking that the RBI deputy governor on the MPC has cast one of the two dissenting votes at the latest meeting (the other dissenter being an outsider). This is indeed a healthy development. One hopes that it will become part of the culture of the MPC in the years to come.

The RBI’s rate cut will not translate into any immediate fall in borrowing costs. For two reasons. One, growth in deposits has lagged growth in credit in the system — the figures for the past year are 9.2 per cent and 11.1 per cent, respectively. Banks have been struggling to raise deposits and had to increase their deposit rates in order to do so. This has implications for monetary transmission.

Transmission in the period January 2015 to March 2018 was near-perfect: A drop in the policy rate of 200 bps translated into a drop in the weighted average lending rate for fresh loans of 205 bps. But this happened in a period when growth in credit was sluggish. It cannot be replicated in a period when credit growth has moved into double digits. 

The big disappointment for the banking sector post-demonetisation is that, contrary to expectations, the share of deposits in disposable income fell by 1.7 percentage points between 2016 and 2018. This is almost matched by an increase in the share of the currency of 1.4 percentage points. How cuts in policy rates can be transmitted in a situation in which banks find it difficult to raise deposits is anybody’s guess.

The other reason that lending rates, in general, will not come down is that risk premia have gone up consequent to the IL&FS debacle. A meltdown in the NBFC sector has been averted. However, banks apprehend that problems in non-banking financial companies (NBFCs) and the real estate sector are not over yet. They are braced for shocks arising from these (and other) sectors. Banks will not think it prudent to cut lending rates across the board and reduce their margins for now. 

The one sector that can expect a reduction in lending rates is the NBFC sector. This follows from the announcement that risk-weights for NBFCs will be in accordance with their ratings. Banks will have to provide less capital for the better-rated NBFCs and hence can cut their lending rates to these. The announcement also frees capital at banks and will improve the capital adequacy ratio at banks. A fall in yields on government bonds will mean capital gains, which will boost capital at banks. 

But the problem of recapitalising public sector banks does not go away. The expected increase in bank capital of around Rs 50,000 crore promised for 2018-19 did not materialise in the recent budget. Nor has there been any allocation for 2019-20. No doubt, the government expects to be able to tap the RBI’s excess reserves for the purpose.

On a broader note, tensions between the government and the RBI have eased. The RBI governor has provided a rate cut. He has indicated that he is open to paying an interim dividend to the government. Three banks are out of the Prompt Corrective Action framework. Small wonder that talk of governance reform at RBI seems to have receded into the background. 
/> The writer is a professor at IIM Ahmedabad
ttr@iima.ac.in