Good reasons not to cut repo rate

The minutes of the Monetary Policy Committee (MPC) meeting of December 6 -7, released by the Reserve Bank of India as required on the 14th day after monetary policy is announced, provide some interesting insights into what prompted the decision to keep the policy repo rate unchanged and also the road ahead.

All six members of the MPC had unanimously voted to keep the policy repo rate under the Liquidity Adjustment Facility (LAF) unchanged at 6.25 per cent in marked contrast to the expectations of the market in general and the banking sector in particular of a reduction of 25 basis points. The 10-page long minutes, which were released on December 21 by the RBI, cover the statement of each member of the MPC under subsection (11) of section 45ZL of the amended RBI Act.

A critical reading of the individual statements show that the focus was on (a) downward inflexibility of Consumer Price Index (CPI) excluding food and fuel, the so-called core component of inflation, (b) dawdling transmission of the cumulative reduction in the recent past of 175 points of policy repo rate to the lending rate of banks and (c) demand shocks/compressions arising out of uncertainties due to withdrawal of Specific Bank Notes (SBNs) impacting the outlook for economic growth.

The MPC members recognised the adverse impact of withdrawal of SBNs – the Rs.500 and Rs.1,000 notes which have been withdrawn – but opined that this will be transitory. On inflation, the voices are sharper and clearer, with one of the MPC members, Chetan Ghate, noting that his “paramount concern at this juncture has to do with the stickiness of inflation excluding food and fuel.” The concern was reiterated by MPC member Dr. Ravindra Dholakia, who noted that there was a “significant chance of the inflation rate exceeding the threshold in March 2017 and in June 2017” and an upside risk to the 5 per cent inflation trajectory for end-March 2017. RBI Executive Director Dr. Michael Patra, also a member of the MPC, reinforced this by noting that “it is critical to stay focused on the inflation target of 5 per cent for Q4 of 2016-17.” And the Governor Dr. Urjit Patel himself mentioned that inflation excluding food and fuel remains sticky, adding his concerns on the cost push inflation due to the seventh Pay Commission award, implementation of GST, and hardening of crude prices. According to him, “achieving the inflation target of 5 percent in Q4 of 2016-17 and securing 4 per cent – the central point of notified the target rate – remains the primary objective.”

This analysis of the undercurrents of the inflation trajectory was clearly missing with almost all the so-called market experts, who proffered simplistic arguments in their zeal to argue for a lowering of the policy repo rate.

Apart from flagging concerns on inflation, the central theme of the minutes is the lack of transmission of repo rate cuts to the credit market. As Chetan Ghate noted: we have an “imperfect  interest rate pass through”; despite a 175 basis point reduction in policy repo rate cut between January 2015 and November 2016, the reduction in the weighted average lending rate (WALR) up to September 2016 was only 71 basis points on the outstanding rupee loans.

The incongruity of banks asking for more cuts but transmitting none of the repo rate cuts already offered has been a concern for some time now. It was a concern Dr. Raghuram Rajan pointed to in a statement on August 9, 2016, where he said: “Despite easy liquidity, banks have passed past rate cuts into lending rates only modestly. Earlier, some bankers had said that it was the lack of liquidity that was holding rates high, now I hear from some that it is the fear of FCNR(B) redemption that is making them reluctant to cut rates. I have a suspicion that some new concern will crop up once the FCNR(B) redemption is behind us. We would be happy if there was more transmission.”

The admittedly weak and incomplete transmission of the policy repo rate to the banks lending rate raises important questions on the way forward for policy repo rate. The transmission of monetary policy is critical to ensure an appropriate interest rate regime which will be conducive to reinvigorating the real section and thereby promoting growth. The markets should appreciate that in the absence of this follow thorough, repo rate cuts – however large or frequent – will remain in a limbo, a powerful instrument rendered ineffective.

In the light of the above, it is important to examine the reasons for incomplete pass through of the policy repo rate to the lending rate. Is it structural, cyclical or technical? The impediments were examined by the Urijit Patel Committee of 2014, which pointed to mostly structural factors like administered interest rates, rigidities in repricing of deposits, interest rate subventions, the coexistence of large informal finance, fiscal dominance through statutory pre-emptions and asset quality.

Recognising this, the RBI and government have taken some initiatives to incentivise the banks to improve transmission at their end. These include government’s reform measures on small savings to make the rates market related rather than administered, the RBI’s guidelines to the banks to adopt marginal cost lending rate (MCLR) and a gradual reduction in SLR, which has moved down from 25 per cent to 20.75 per cent.

Since the structural rigidities have been addressed at least in some measure, it would be reasonable to expect banks to now become pro-active in cutting lending rates rather than asking for more repo policy rate cuts. But the banks themselves have been caught in a vortex arising out of the uncertainties and weak business sentiment following the sudden withdrawal of SBNs. Today, there is a lack of clarity on the road ahead and this in itself is a stumbling block for banks to proactively cut lending rates. While this may be transitory, the duration of this transition remains an unanswered questioned.  

Given this complex situation, the wait and watch policy is likely to continue and a policy repo rate cut will likely be on hold for some time now.

(R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR)