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RBI's policy stance

2/04/2015 marked 80 years since Reserve Bank of India has been in operation. It has been wonderful 80 years of operations- managing the impossible trinity ain't am easy task & it has been doing it since ages. Impossible trinity in economics refers to managing exchange rates, inflation & industrial growth in a country (more on that in the other article).

RBI has a policy of bi-monthly policy review in a year, wherein it conducts a review of the policy in force & modifies it if the need be. In its recent review on 07/04/2015 RBI kept its policy rate and CRR & SLR unchanged against the expectations of many bankers.

First up is the purpose of RBI. RBI is a regulator of financial markets in India, majorly of banking sector. It is basically the central bank of India much like Federal Reserve in USA. It can release policy statements & thereby effect the rates in Indian economy by changing Repo rates, CRR & SLR. All banks in the country then accordingly change their deposit & lending rates.

Thus the transmission of this policy to retail customers is dependant on the banking sector-which till now was regular. The central bank affected two unexpected rate cuts in the first quarter of calendar year 2015 which led to repo rate coming down to 7.5%. (repo rate is basically the rate at which the central bank lends money to banks with government security as collateral). Now, with the sudden change in the trend, RBI kept all the rates constant making its stand dovish on economy.

The reason cited for such a sudden change is that monetary policy is not being transmitted to the retail public in the economy. With change in repo rate, RBI affects the rates in the economy. Just as we borrow money from banks, the banks borrow money from RBI. So when the Repo rate is higher the cost of funds to banks is higher & similarly, when the cost of funds is lower to the banks the banks charge a lower rate on loans. However, one more source for banks for funds is the deposits they accept from general public(which till some time back was decided by RBI, but now has been deregulated & can be decided by individual banks). So, some banks provide interest rates as high as 6% on deposits.

Analysing the spread banks earn & further considering NPA provisions made by banks, the costs have sky rocketed for banks which is leading to non penetration of monetary policy by the banks to the economy as banks aren't reducing the loan rates. This is leading to low investments by corporates in expansion & diversification and higher rates on deposits is leading to low investment by people in markets & more in bank deposits. Finally this cycle is leading to a cash hungry economy.

One of the main reasons however for high interest rates is the asset quality of banks. On one hand deteriorated assets are leading to higher provisions & lowering of rates will lead to a risk of further deterioration of asset quality. So the RBI has urged the banks to further penetrate the policy & that is when it will think of further easing in monetary policy. Provided below is a table including some of the largest banks & the spread they are earning on their operations.


In India, typically the sources of funds for banks has been the deposits they get from retail consumer. However, in overseas banks, corporate borrowings also plays a major role in the funds banks get. So, repo rate is basically one of the factors which banks consider for their interest rates on loans. So to sum up in the end, some of the reasons enumerated above include-
Deposits- the deposits banks get from customers is falling from some time now and without any alternative source of funds in mind, banks are keeping the rates high.
Asset quality- the asset quality issue for banks has been around for quite sometime now. Moreover, as per recent reports the asset quality has further deteriorated now. For PSU banks, the Gross NPA stand at 5% & for the private banks, Gross NPA stand at 2.1% which leads to an average of 4.2% of Gross NPA in the system. The proportion is very high. Also, looking in the hindsight, if the fall in interest rates in India by central bank leads to fall in base rate then this assumption is wrong. During the last easing cycle in January 2012- mid 2013, the rates- repo rate & Cash Reserve Ratio were lowered by 100 bps & the banks only responded by lowering the base rate by 40 bps.

As per this analysis, what could lead to a faster penetration of monetary policy lies in stronger demand,  supportive fiscal policy and redressal of banks issue of stressed assets. This seems like a long drawn process, which RBI should think of implementing in consultation with Ministry of finance.


Cheers!
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