Monetary policy transmission in India

  • October 18, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Monetary policy transmission in India

Subject :Economy

Section: Monetary Policy

The RBI’s rate hikes since 2022 have highlighted a disparity in the transmission of policy rate changes, with lending rates increasing at a slower pace compared to deposit rates. This phenomenon has been particularly noticeable in the current economic cycle, presenting various implications for different stakeholders in the financial system.

  • Deposit Rate Increase: The Weighted Average Domestic Term Deposit Rates (WADTDR) for fresh deposits have witnessed a significant rise, partly driven by banks’ requirements for funds to support rapid credit growth. Larger depositors have received relatively higher rewards compared to smaller ones.
  • Limited Transmission in Lending Rates: Despite the policy rate hikes, lending rates have not increased at a proportionate rate. The overall increase in lending rates has been notably lower than that of deposit rates, with existing loan rates exhibiting a slower rise.
  • Impact of CASA Deposits: Banks have managed to maintain lower lending rates by leveraging their current account and savings account (CASA) deposits, which constitute a significant portion of their total deposits. These accounts have not experienced any changes in interest rates during this cycle, allowing banks to sustain comparatively lower lending rates.
  • Effect of MCLR and EBLR Loans: While a significant proportion of loans (around 44.8%) remain linked to the Marginal Cost of Funds Based Lending Rate (MCLR), the transmission of rate changes is relatively slower due to various operational factors influencing the MCLR calculation. Conversely, loans (around 50.2%) linked to the External Benchmark Linked Loan Rate (EBLR) have the advantage of immediate resetting when policy rates change, ensuring a more rapid transmission of rate changes.
  • Competition for Deposits and Incremental Credit: Tight liquidity conditions have intensified competition among banks for deposits, potentially leading to increased rates for depositors. Simultaneously, competition for incremental credit might have restrained some banks from sharply increasing lending rates, especially in specific segments like housing, vehicle, and education loans.

About Internal Benchmark Lending Rate (IBLR):

  • Lenders establish an internal benchmark rate for determining interest rates on loans.
  • Several benchmark rates were introduced over the years, including BPLR, Base Rate, and MCLR.
  • These rates aimed to ensure transparent and efficient pricing in the lending market.

Issues with IBLR Regime:

  • Banks often did not pass on the full benefits of RBI’s repo rate cuts to borrowers.
  • Complex internal variables within the IBLR-linked loans hindered the seamless transmission of policy changes.

BPLR (Benchmark Prime Lending Rate):

  1. Used as a benchmark rate by banks for lending until June 2010.
  2. Loans were priced based on the actual cost of funds.
  3. The rate varied across banks and depended on the cost of funds, among other factors.

Base Rate:

  1. Replaced BPLR and was used for loans taken between June 2010 and April 2016.
  2. Considered the minimum interest rate at which commercial banks could lend to customers.
  3. Calculated based on the cost of funds, unallocated cost of resources, and return on net worth.

MCLR (Marginal Cost of Funds based Lending Rate):

  1. Introduced in April 2016 as a benchmark lending rate for floating-rate loans.
  2. Considers the marginal cost of funds, negative carry on account of the cash reserve ratio, operating costs, and tenor premium.
  3. Linked to actual deposit rates, ensuring that when deposit rates rise, MCLR increases and lending rates go up accordingly.

External Benchmark Lending Rate (EBLR):

  1. RBI mandated the adoption of a uniform external benchmark by banks from October 1, 2019, it was intended to plug the deficiencies in MCLR.
  2. Four external benchmarking mechanisms were introduced, RBI repo rate, 91-day T-bill yield, 182-day T-bill yield, any other benchmark market interest rate as developed by the Financial Benchmarks India Pvt. Ltd.
  3. Banks have the flexibility to set the spread over the external benchmark, with interest rate resets required at least once every three months.

Significance of EBLR:

  1. Aims to facilitate faster and effective transmission of monetary policy changes.
  2. Enhances transparency in interest rate setting and standardizes the process of fixing interest rates for different loan categories.
  3. Introduces a more dynamic and responsive lending environment in line with the objectives of the RBI’s monetary policy framework.

Monetary Policy Normalization in India:

  1. Involves adjustments made by the Reserve Bank of India to control the amount of money in the economy.
  2. Entails a shift from a loose monetary policy, involving increased liquidity and reduced interest rates, to a tight monetary policy that raises interest rates and reduces liquidity.

Reverse Repo Normalization:

  1. Refers to an increase in the reverse repo rates by the Reserve Bank of India.
  2. Part of the broader strategy of monetary policy normalization to counter rising inflation and bring the rates back to their usual positions.
  3. Aims to reduce excess liquidity, elevate interest rates across the economy, and discourage excessive borrowing by consumers and businesses.

Repo Rate:

  • The rate at which the RBI lends short-term money to banks against securities.
  • One of the key tools used by the central bank to control the money supply in the economy.

Reverse Repo Rate:

  • The rate at which banks park their short-term excess liquidity with the RBI.
  • Used by banks when they have surplus funds that they are not able to invest for reasonable returns.

SLR (Statutory Liquidity Ratio):

  • Mandates that every bank maintain a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold, and un-encumbered approved securities.
  • A tool used by the RBI to restrict the bank’s leverage position to pump more money into the economy.

CRR (Cash Reserve Ratio):

  • Mandates that banks hold a certain proportion of their deposits in the form of cash with the RBI or currency chests.
  • Used by the RBI to control liquidity in the banking system and ensure that banks have enough cash to meet their payment obligations.

Marginal Standing Facility (MSF):

  • A window for banks to borrow from the Reserve Bank of India during emergency situations when inter-bank liquidity dries up completely.
  • Banks pledge government securities at a rate higher than the repo rate under the Liquidity Adjustment Facility (LAF).
economy Monetary policy transmission in India