Transmission Lag in Monetary Policy

The first bimonthly monetary policy review on 4th October 2016 after the constitution of MPC by India resulted in 25 basis point rate cut, immediately triggering a narrative of hope and growth. Economic Affairs Secretary expected banks to follow it up with effective transmission of rates. The SBI chair believed banks will continue to transmit rates based on evolving liquidity scenario. CII anticipated that the RBI intervention to reduce interest rates would enable banks to transmit the cut to borrowers, thereby supporting the growth cycle. The traditional economic thought and theory support these views. I, however, have a deep rooted apprehension, resulting from the way banks fix interest rates on deposits.

Interest rates on deposits used to be mandated by RBI and the maximum rate on term deposits used to be 10% until 1981 when Dr. Manmohan Singh as Governor, RBI, for the first time raised it to 11%. The rates were applied uniformly across banks. The second notable feature was that the interest rates on term deposits were contracted when deposit was made or accepted. For the remainder of the term of the deposit the interest rate would remain fixed. In subsequent years some deregulation happened and banks were allowed to fix interest rates for themselves. This has led to a competitive environment particularly after the entry of private banks in the field. However term deposits carrying a fixed rate of interest still dominate the banks' time and demand liabilities, called TDLs. The banks continue to pay high rates of interest for the remainder of the term of the deposit after the deposit is accepted. With high cost of bulk of resources, banks can't be expected to effectively pass on the rate cut to all existing borrowers. However new borrowers can surely benefit. When old high interest rate bearing deposits are paid and new deposits are made, intetest rates on these new deposits will come down enabling banks to transmit rate cut. This, I believe, is the primary source of transmission lag.

The existing borrowers whose expectations are raised by transmission talk, in my opinion, are in for a bit of disappointment. The existing depositors are, however, likely to continue to enjoy high real yield on their deposits. This, to some extent, may be said to be unfair in the sense that this comes at the cost of the consumer and indeed economy as a whole for this results in high cost of funds for investment and inflated prices of goods and services. When high inflation leads to a raise in interest rates, the reverse is also true for the existing deposits will continue to attract lower rates, possibly negative real rates. That is equally unfair. Both situations need correction. A possible solution is that RBI as regulator of banking sector makes it mandatory for banks to tie interest rates on term deposits and possibly advances to repo rate so that whenever there is a change in this policy rate it is automatically transmitted to depositors and borrowers. That however is too simplistic solution and on the flip side leaves nothing in the hands of banks in case they face any issues. Economists and RBI officials have to come up with workable solutions balancing the need to reform the interest rates transmission and appropriate leeway with banks.

Another reason for lag in transmission or sometime even a lack of transmission, is the market distorting small savings and social security schemes like employees provident fund. These schemes are competitors to bank deposits. Continued high interest rates on these schemes will naturally have a negative impact on transmission process.

I am keeping my fingers crossed and waiting to see some REFORMS in these areas. While the former lies in the sphere of RBI the later will be dealt with by the ministry of finance. Reserve Bank of India has an added incentive to act swiftly as this will make the instrument of interest rate in the hands of monetary policy committee much more effective. Tackling small savings and EPF intrest rates is much more ticklish because of the pressure groups particularly labour organisations. But ensuring positive real yield on deposits and social security schemes at all times is of utmost importance, no less than keeping inflation in check. That makes REFORMS in these two areas imperative.