RBI needs to work on improving monetary policy transmission
The Reserve Bank of India (RBI) Monetary Policy Committee (MPC) meeting is expected to cut interest rates by 25 basis points. This will follow the two 25 basis point rate cuts in the previous two MPC meetings of the RBI. A cut in the policy rate will be welcome but needs to see a much stronger transmission to interest rates in the economy.
In the immediate context, the RBI needs to address liquidity concerns. The non-performing asset (NPA) crisis in banks had resulted in a credit crunch. Credit growth moved to Non Bank Financial Companies (NBFCs), which were able to raise money from the bond market and from banks. After the IL&FS crisis, the NBFC sector has seen rising defaults, and is increasingly finding it difficult to raise money. Mutual funds, provident funds and pension funds, which were largely the buyers of NBFC commercial paper, have reduced their lending to NBFCs.
Formula based cost of lending
To improve transmission, the RBI has experimented with many frameworks for banks’ interest rates to reflect the policy rate. These mechanisms have included linking rates to a benchmark lending rate, to linking lending rates to a marginal cost lending rate. Under these frameworks, formulae link bank lending rates to the cost of borrowing. However, the cost of borrowing takes a long time to come down as a significant chunk of the borrowing comes from fixed deposits. There are also rigidities in the savings rate as most public sector banks set the savings account rates not as individual banks who make their own business decisions, but in line with what other public sector banks do. As a consequence, lending rates take much longer to come down.
Competitive banking system
The RBI has sought to reduce lags and to improve transmission by changing the formulae. While this may have helped to some extent, is it a short term fix. The longer term solution to a greater and faster transmission of the policy rate to bank lending rates lies in a competitive banking system when banks compete to lend to customers at attractive rates. The RBI policy of banking licences on tap has led to some small banks getting licences and two commercial bank licences being given since 2013. The RBI needs to move faster on this agenda.
Banking sector reform will not lead to an immediate change in the way transmission happens, but in the medium term this will have an effect on transmission of policy rates to bank lending rates. The RBI needs to move on this agenda now to start proceeding in the right direction. This has to be part of a larger agenda to reform India’s banking sector.
The third element of policy change required for improving transmission of policy rates into the wider economy is bond market reforms. The agenda from a deep and liquid “corporate” bond market has been discussed many times. Many a committee report has made recommendations for reforming the corporate bond market. While these have had some impact, and for some time last year, it appeared that the corporate bond market was growing fast, a lot of the growth was shallow and was due to the growth of NBFCs funded by short term bond purchases by mutual funds and banks. The growth was not widespread as in the case of equity markets. Money was not being raised as much directly by companies as by financial intermediaries who were on-lending the funds.
In financial markets in other countries, bond markets are not fragmented into a corporate bond market and a government bond market. The same buyers and sellers participate in both bond markets, which have the same market infrastructure (trading platforms, clearing houses and depositories) and the same regulators (who make rules for participation, buying and selling bonds and to whom compliance needs to be done).
The Indian bond market is still in its infancy. As a first step, India needs to get rid of the regulatory and infrastructure fragmentation. Second, and most importantly, it needs to set up an independent Public Debt Management Agency, whose job is to issue and trade government bonds. Today this job is being done by the RBI, which not only issues these bonds, but also owns and regulates the exchange, clearing house and depository on which they are sold and held.
Public Debt Management Agency
This reform requires legislative change. The required legislative change was first proposed in March 2015, but was withdrawn to allow time for the RBI to prepare a transition path. Since four years have passed, this should now be taken up again as soon as the government settles down to legislative business. The setting up and development of capacity for a vibrant bond market will also have other positive effects, such as reducing the cost of government borrowing, bringing down bank maturity mismatches, creating a platform to bring long term savings from pension and insurance into infrastructure, etc . The transmission of monetary policy will be both faster and greater. However, this work needs to be started now so that its benefits can be reaped after the three to five year period it takes for such a reform to be effective.