Doubts over monetary policy efficacy as previous cuts not transmitted
Interest rate hikes are barreling towards us, but ironically, the previous rate cuts haven’t been fully transmitted yet, raising doubts over the efficacy of monetary policy transmission. Of the 250 bps reduction in the policy repo rate since February 2019, the weighted average lending rates (WALRs) on fresh and outstanding rupee loans declined only by 213 bps and 143 bps respectively.
Repo and reverse repo rates were last reduced in May, 2020 and despite a near two-year lag, the pass-through is incomplete, especially for existing borrowers, where the shortfall is as high as 107 bps or 1.07%. The imminent rate hike cycle implies that this set of borrowers may never be able to see the full benefit of the about-to-expire ultra-low rate regime.
What’s dispiriting is that the central bank’s trials and tribulations to improve transmission dates back to three decades, but have yielded little. Starting with the prime lending rate (PLR) in 1994 to the benchmark PLR (BPLR) in 2003 to the base rate in 2010 and MCLR in 2016, the RBI has been periodically attempting to improve monetary transmission and impart transparency to the lending rates setting process.
The current system namely External Benchmark Rate (EBR) was rolled out in October 2019, and a recent RBI study notes that transmission has improved and that EBR has accelerated the pass-through even to MCLR-linked loans, as changes in the benchmark rates led banks to proactively adjust their deposit rates to protect their margins, thereby improving transmission to overall lending and deposit rates.
Other data supporting this view include the increase in the proportion of floating rate loans linked to EBR. From 28.6% in March, 2021 of total loans, EBR-linked loans shot up to 39.2% in December, 2021. The share of MCLR-linked loans is still the largest at 53.1%, but the sustained decline in the MCLR and the periodic resetting of such loans at lower rates led to a softening of WALR on outstanding loans. The WALRs on personal loans and loans to MSMEs too declined significantly during the period October, 2019-February, 2022. The decline was sharpest for personal loans at 222 bps followed by vehicle loans at 208 bps and loans to MSMEs at 194 bps.
The efficacy of monetary policy depends on the pace at which policy rate changes are transmitted to the real economy. In India, transmission has been smooth at the short end of the maturity spectrum while the pass-through to bank lending and deposit rates remains relatively sluggish. There is evidence of asymmetry in pass-through from repo rate changes to banks’ lending and deposit rates.
On the face of it, the pass-through of policy rate changes to interest rates on term deposits appears larger compared to lending rates. Term deposits constitute only 56.2% of aggregate deposits as on March 2022, while current account and savings account deposits constitute 9.8 and 33.8% respectively. Current account balances do not earn any interest and hence are largely impervious to policy rate changes. Transmission to savings account rate is typically subdued and modest, relative to term deposits. So if you take into account current account and savings account deposits, the pass-through of rate changes isn’t as acute.
Despite 2-year lag, Pass-through incomplete
Repo and reverse repo rates were last reduced in May, 2020 and despite a near two-year lag, the pass-through is incomplete, The imminent rate hike cycle implies that this set of borrowers may never be able to see the full benefit of the about-to-expire ultra-low rate regime