Explained: Why interest rates aren’t falling

Headline : Explained: Why interest rates aren’t falling

Details :

Context for the article:
  • This article explores why, despite significant repo rate cuts by the RBI, the interest rates in the banking system are not falling much.
Rate cuts by the RBI:
  • Since February, the Reserve Bank of India (RBI) has aggressively cut the repo rate.
  • Repo rate is the interest rate that the RBI charges the banks when it lends them money.
Why does RBI want lower interest rates?
  • Since February, India’s economic growth momentum has rapidly decelerated.
  • Projections of GDP growth rate have come down from roughly 7.2%-7.5% in February to 5.8%-6.0%.
  • There are two key problems in the economy – Consumption and Investment – and a lower interest rate regime is expected to help in resolving both.
  • To this end, RBI has been cutting repo rates, especially since overall retail inflation has been well within the RBI’s comfort zone of 4%.
Lower interest rates could revive consumption:
  • The main issue is that people are not consuming at a high enough rate.
  • Some economists argue that if banks reduce their lending rates, they would also have to reduce their deposit rates (the interest rate banks pay when we park our money with them in a savings bank deposits or a fixed deposit).
  • This, in turn, will incentivise people to save less and spend more.
Lower interest rates could revive private investment:
  • The other problem in the economy at present is that businesses are not investing in existing or new facilities.
  • Part of the reason is also that the interest rate charged on loans is quite high.
  • If banks reduce the interest rates on loans, more businesses are likely to be enthused to borrow new loans for investment.
  • This is particularly relevant with the recent corporate tax rate cuts done in the hope that it will boost the corporate sector’s profitability and get it thinking of investing more.
 
The ‘transmission’ of rate cuts by RBI to the banking system is not happening:
  • By cutting the repo rate, the RBI has been sending a signal to the rest of the banking system that the lending rates in the system should come down.
    • Lending rates are the interest rates that banks charge from their customers.
  • This process of repo rate cuts leading to interest rate cuts across the banking system is called “monetary policy transmission”.
  • The transmission process in India is quite inefficient:
    • For example, between February and August, the RBI cut repo rate by 110 basis points — 100 basis points make a percentage point — from 6.5% to 5.4%.
    • But, the interest rate charged by banks on fresh loans that they extended during this period fell by just 29 basis points – that is just 27% of the amount by which the repo rate came down.
To force transmission, RBI is linking bank lending rates to repo rate:
  • Concerned by the sluggish transmission, the RBI in October 2019 (after cutting the repo rate by another 25 basis points) took steps to make banks link their lending rates to the repo rate.
  • The RBI made it mandatory for all banks to link certain loans to external benchmark rates like Repo Rate, Yields on treasury bills etc.
Only few banks have cut rates:
  • For the most part, the banking system has ignored RBI’s signalling and only some banks have reduced lending rates on new loans by 10 basis points.
  • In essence, while the RBI has cut its lending rate to the banks by 135 basis points (or 1.35 percentage points) in the nine months since February, the interest rates being charged to the common consumer have come down by only about 40-odd basis points.
Why aren’t interest rates in the banking system coming down?
  • The interest rates in the banking system are not coming down despite repo rate cuts by the RBI.
  • This is because repo rates have little impact on a bank’s overall cost of funds, and reducing lending rates just because the repo has been cut is not feasible for banks.
Difference between lending and deposit rates allows banks to function:
  • For any bank to be viable, there must be a clear difference between the lending rates (interest rates it charges from borrowers on loans it provides) and the deposit rates (interest rate it gives to consumers on deposits it accepts).
  • The difference between these two sets of interest rates has to be not only positive but also big enough for the bank to make profits.
Banks can be profitable only if they cut deposit rates also:
  • To attract deposits, banks pay a high deposit rate. Such deposits make up almost 80% of all banks’ funds from which they then lend to borrowers.
  • Banks borrow only a small fraction under the repo.
  • So even sharply reducing the repo rate doesn’t change the overall cost of funds.
  • Unless banks reduce their deposit rates, they will not be able to reduce their lending rates.
Why are banks not reducing their deposit rates?
  • Others could offer better rates: That’s because if a bank were to reduce its deposit rates, depositors would shift to a rival bank that pays better interest rates or invest in small saving instruments such as public provident fund, Sukanya Samriddhi Yojana etc that pay much higher interest rates.
  • Can’t reduce rates immediately: Even if banks wanted to reduce their deposit rates, they can’t always reduce them immediately. This is because 65% of total deposits are “term” deposits (fixed for a certain duration) and take, on an average, up to two years to get repriced at fresh rates.
What hasn’t linking the lending rate to the repo rate worked?
  • This is not a viable solution for the banks.
  • The banks cannot link their lending to the repo rate because repo doesn’t determine their cost of funds.
  • For a repo-linked regime to work, the whole banking system would have to shift to that – in other words, along with banks’ lending rates, their deposit rates too must go up and down with the repo.
  • But if such a regime were in place, depositors would have earned 1.10 percentage points less interest rate on their savings account.
Is this problem of weak transmission new?
  • As per some experts, this is not a new issue.
  • Never even in the past has monetary transmission been better than 50% (that is, only half the rate cuts by RBI were passed through by the banking system).
  • The reason for weak transmission, too, has been largely the same.
Why doesn’t this happen in developed countries?
  • The slow transmission does not happen in developed countries because the financial system is far more developed and diversified.
  • Banks are not burdened to fund everyone:
    • Most importantly, the banking system there doesn’t have to bear the burden of providing loans to everyone in the economy – from farmers to small businesses to large businesses, like in India.
  • Developed bond market:
    • Most demands for big loans are directed towards the corporate bond market – wherein a company floats bonds (or IOUs) and borrows money from the public by paying whatever interest rate the market demands.
  • Better grasp of borrowing and lending dynamics:
    • Depositors there are not in the habit of getting a fixed interest rate on their savings while expecting a variable interest rate on their loans.
    • The savers there are far more willing to take risk and to invest in higher-risk instruments other than bank deposits.
    • On the other hand, at the current low levels of per capita income, Indian savers are risk averse and prefer saving in banks.
  • Government borrowing does not impact interest rates much:
    • The overall borrowing by the public sector – that is the government and government-owned institutions – is not so high so as to drive up the interest rates in the economy, as it happens in India.
Section : Economics

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