Why repo rate cut does not guarantee economic growth

It doesn't necessarily inject fresh liquidity into the system.

 |  3-minute read |   09-08-2016
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It is curious to know that the Reserve Bank of India's (RBI) repo rate under the liquidity adjustment mechanism is not really a window for banks to borrow clean funds from RBI to lend to their customers.

It is a means of funding by the RBI, the excess government securities held by banks so that it frees bank's deposits for deployment towards lending.

Loans given out by banks and statutory assets held by banks are funded by their own capital and customer deposits, and not by borrowing funds from the RBI through the repo window.

For loan interest rates to come down, the cost of capital needs and bank deposit rates needs to come down.

Lower repo rates should therefore mean lower government security yields, since it reduces their cost of funding.

Lower risk-free government security yields should mean other bond (corporate) yields should come down as well.

Taking recourse to cheaper funds available through wholesale debt markets, banks will be able to lower deposits and in turn lower lending rates.

rbi-embed_080916072818.jpg Policy rates of the RBI are of interest to the financial sector.

Repo rate cuts do not necessarily inject fresh liquidity into the system. Banks are still left to compete for their share of bank deposits.

Injecting liquidity and supply would do a lot more than policy rate cuts to bring down deposit rates.

Also, the base lending rate of each bank is determined on that bank's cost of funds.

If a chunk of funds available to banks is in the form of non-interest bearing current accounts or low and fixed interest-bearing savings accounts, the cost of funds changes slowly compared to change in term deposit rates.

Lower government security yields means lower returns from statutory assets of the bank, which increases the loan asset's burden.

Taken together, the marginal reduction in deposit rates does not translate into concomitant reduction in lending rates.

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This results in sluggish movement of bank deposit rates and quite obviously in even slower movement of bank lending rates.

Policy rates of the RBI are of interest to the financial sector, while the real sector is more concerned about slower moving base rates; base rate hardly moves in tune with government bond yields.

A bank's base rate must therefore be linked to a risk-free floating rate and not to its cost of funds.

If the bank was to take no credit risk, it would deploy all its funds into risk-free government bonds.

As it assumes credit and liquidity risk, it will demand a higher return than the risk-free rate.

The lowest lending rate should be therefore a floating risk-free rate on a good spread, representing liquidity premium and minimum credit spread. This will have the following advantages:

A) Transparency across banksB) Transmissions of policy rate will be clearer and instantC) The real sector will also be able to risk manage interest rate risks, including interest rate futures, without the risk of hedgingD) Development of a term structure of interest rates that the Indian market has been looking for

From the bank's point of view, deposit rates will have to be linked to the same risk-free rates by using the same tools as the real sector, such as derivatives linked to interest rate futures without hedging.

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The RBI can sometimes transmit policy interest more efficiently through market liquidity than policy rate action.

Liquidity shortage transmits rate hikes and conversely liquidity injection transmits true rate reduction or cut.

The RBI desirably keep its liquidity policy options open, rather than resorting to a state of perennial liquidity shortage aiming at rate hikes or liquidity injection to effect rate reduction or cuts.

Therefore, repo rate cut does not necessarily translate to lowering of lending rates and hence may not be a solution for lagging economic growth.

Writer

K Srinivasan K Srinivasan @krishsri59

The author is a GST reader and writes on macroeconomics and indirect tax laws.

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