Unlike his predecessors (read: Raghuram Rajan: 2013 – 2016 and Urjit Patel: 2016 – 2018) who used changes in the policy rate – interest rate charged by the Reserve Bank of India (RBI) on loans it gives to banks – primarily as an instrument of targeting inflation, the incumbent governor, Shaktikanta Das has used it mainly for spurring economic growth but without much success. Das – a former economic affairs secretary – who took charge in December 2018 after untimely exit of Urjit Patel handed out a cumulative reduction of 1.35% during 2019. As a consequence, the rate was down to 5.15%.
In the wake of deadly Corona virus, just after the first phase of lockdown announced by Prime Minister, Narendra Modi and deviating from the normal practice of making major policy announcements as part of the bi-monthly monetary policy review, on March 27, 2020, Das announced a further reduction in policy rate by 0.75% to 4.4%. In less than a month, on May 22, 2020, he announced yet another cut of 0.4% – bringing the rate down to a record low of 4%
Now, as the RBI gears up to present the next bi-monthly policy review in the first week of August, 2020, there is a possibility of the governor announcing yet another cut in the policy rate.
A reduction in the policy rate signals banks that they should undertake corresponding reduction in the interest rate, they charge from their borrowers viz. industrial and business enterprises, individuals etc. By reducing the cost of capital (other things remaining same), this increases the profitability of firms thereby adding to their internal surplus and in turn, gives a boost to investment demand. On the other hand, for individuals who have taken loan (for home, car or any other durable item), the resulting cut in the EMI (equated monthly installment) leaves more money in his/her hands thereby adding to purchasing power and giving a boost to consumer demand. The fillip to both investment demand and consumer demand is a sort of ‘double engine’ that should help in accelerating growth.
Things should pan out as indicated above provided the required funds are actually available from banks at lower interest rate and that industries, business enterprises besides individuals face no other constraint.
In less than 18 months, there has been an unprecedented cut in policy rate by 2.5%; of this 1.35% during 2019 when there was no Corona crisis. Despite this, during 2019-20, growth in GDP (gross domestic product) plummeted to a low of 4.2%. In fact, there was progressive reduction in growth from quarter-to-quarter declining to a decade low of 3.1% in the quarter ending March 31, 2020.
Why did rate cut (albeit substantial) didn’t produce the desired result? What explains this anomalous situation?
At the outset, as per governor’s assertion, banks transmitted just about half of the cumulative reduction of 1.35% to borrowers. From this, do we infer that the banks pocketed the balance half thereby boosting their own profitability thereby denying borrowers the much needed relief? That would be an over-simplification.
The bank normally prices loans given to customers after taking into account the cost of its funds (an overwhelming share of these comes from public deposits of varying maturity say one year, 2 years and so on) plus the cost of maintenance and management of deposits and loans (mostly incurred towards wages and salaries and other overheads) plus a mark up for the profit of the bank. The money that it borrows from the apex bank (policy rate relates to such borrowings) constitutes a small portion of the total.
Therefore, the lending rate can’t be related only to the policy rate notwithstanding RBI goading banks to use the latter as the benchmark. If, a major slice of its funds are from term deposits on which the bank has committed to pay high interest, the same has to necessarily get reflected in pricing of loans. On incremental deposit, it could charge less (to align with lower policy rate) but the overriding impact of past high cost deposit can’t be wished away.
There is another potent reason as to why the mis-match would arise. This has to do with the galloping non-performing assets (NPAs) – a sophisticated nomenclature for a loan going bad. When, that happens and the account is referred for proceedings under the Insolvency and Bankruptcy Code (IBC), the bank has to make huge provisioning viz. 50% for secured loans and 100% for unsecured loans. This cost has to be absorbed somewhere; indeed this is another major factor why the lending rates can’t be lowered beyond a point.
It is therefore, abundantly clear that the quantum of reduction in lending rate by individual banks is bound to be lower than the cut in the policy rate and given the underlying factors, there is little they could do to achieve perfect alignment between the two.
Mere reduction in lending rate by itself won’t be of much help unless additional credit is available to firms at the reduced rate. This has not happened. The growth in bank credit during 2019-20 at 6.1% was less than half of the growth during 2018-19 at 13.4%. Apart from compression in demand (due to massive loss of jobs and decline in incomes), this has also to do with high NPAs and increasing risk aversion of bank while lending.
A deadly cocktail of all these factors has thus ensured that much of the anticipated boost to growth from the substantial reduction in the policy rate failed to materialize. The last quarter of 2019-20 in particular, also had to face the brunt of slump in global demand even as the Covid – 19 induced crisis had already embraced several countries including USA and European Union (EU) countries to whom India exports in substantial measure.
During the current year also, Das continued with the rate reduction spree with a further cut in the rate by cumulative 1.15%. He supplemented this with a host of measures to inject liquidity in the country’s financial system. These measures announced on March 27/April 17, 2020 have made available plenty of liquidity close to Rs 500,000 crore. The RBI has also incentivized banks to lend money to businesses. For instance, it has cut the reverse repo rate (interest rate banks get on funds they keep with apex bank) from existing 4% to 3.75% to discourage them from keeping their funds idle.
But, all of this is coming at a time when, the devastating effect of Covid – 19 is playing out on the economy. During the full lockdown period, all economic activities (but for bare essentials such as food supply, medical services etc) were shut. Even after there was exit from the lockdown and activities resumed, those were on a substantially reduced scale. The short point is, the compulsions of sticking to ‘social distancing’ norms (a must to rein in spread of the pandemic) is the biggest stumbling bloc in the way resuming businesses.
Meanwhile, the problems that gripped the banks during 2019-20 continue to haunt them during the current year with greater intensity. In fact, the NPAs which had shown some reduction are projected to surge by close to Rs 600,000 crore by March 31, 2021 (under a worst case scenario). For now, the moratorium on repayment allowed by RBI till August 31, 2020 (there is demand for extending it further) is keeping a lid; when it ends, the real impact will come to the fore. That will cause substantial erosion in bank’s capital and in turn, their ability to lend as well as lower the lending rate.
In this backdrop, it makes no sense for the RBI to keep on lowering the policy rate. It sounds like the driver merely pressing the accelerator while the car is stationary. He will only end up burning fuel without any outcome. Far from helping in giving a boost to growth (as the real bottleneck lie elsewhere), this will do a collateral damage. For instance, the compulsion to reduce lending rate will force banks to reduce deposit rate thereby affecting millions of depositors.
It is necessary that RBI applies brakes on its spree of lowering the policy rate. Meanwhile, all stakeholders should make all out efforts to defeat Corona expeditiously as that will help early resumption of economic activity and revival of growth perhaps even with some rollback of previous cuts.