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Monetary Transmission in India: Why is it important and why hasnít it worked well? (Dr. Viral V Acharya, Deputy Governor - November 16, 2017 - Inaugural Aveek Guha Memorial Lecture, Homi Bhabha Auditorium, Tata Institute of Fundamental Research (TIFR))

Monetary Transmission in India: Why is it important and why hasnít it worked well? (Dr. Viral V Acharya, Deputy Governor - November 16, 2017 - Inaugural Aveek Guha Memorial Lecture, Homi Bhabha Auditorium, Tata Institute of Fundamental Research (TIFR)) - News and Press Release - Dated:- 17-11-2017 - When I travel from my residence in Vile Parle (W) to the Reserve Bank of India Central Office in Fort, I pass each way Kenilworth - the birth place of late Homi Jehangir Bhabha. It is a good way to s .....

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ly how all research needs to be, taking on seemingly insurmountable challenges, fighting it out with grit, and along the way, dissecting, reflecting, and distilling truth to its essence until it is unearthed in some recognizable form from beneath its scratchy exterior. The TIFR is a daunting proposition for any researcher to speak at. I hope that I can progress some way towards meeting its highest standards in the form of this talk, by raising an issue that is germane to all of us in today s for .....

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the amended RBI Act is mandated to determine the policy repo rate to achieve the specified medium-term inflation target of 4 per cent, within a band of +/- 2 per cent. For the Reserve Bank to achieve its mandate effectively, it is extremely important that an economic process referred to as monetary transmission works seamlessly. Any impediment to this process of monetary transmission hampers the achievement of our mandate. We, therefore, monitor and analyse monetary transmission on a regular bas .....

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is the entire process starting from the change in the policy rate by the central bank to various money market rates such as inter-bank lending rates, to bank deposit rates, to bank lending rates to households and firms, to government and corporate bond yields, and to asset prices such as stock prices and house prices, culminating in its impact on inflation and growth. The transmission mechanism hinges crucially on how monetary policy changes influence households and firms behaviour. This change .....

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ary ones being (i) interest rate channel, (ii) credit channel, (iii) exchange rate channel, and (iv) asset price channel. Let us start with how the interest rate channel works. The immediate impact of a change in the monetary policy rate is on the short-term money market rates (such as call money rate, certificates of deposits, commercial papers, treasury bills), key financial markets (exchange rate, equity prices), and also on medium and long-term instruments (yields on dated government securit .....

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central bank s policy rate. The impact of the policy rate on other market rates varies across tenors and instruments depending upon the liquidity conditions and other factors such as how interest rates vary at different maturities. In turn, the central bank s changes in its policy rate are expected to impact the banks cost of funds, both the rates they would pay to depositors and the rates they would demand for making loans. For example, when a central bank reduces the policy repo rate with the .....

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eneurs for new or increased investment in plant and machinery. An increased demand for automobiles, housing, and machinery generates increased demand for the inputs including labour in these industries, and hence, an increase in overall demand, incomes, and output in the economy. As this process continues, it eventually puts upward pressure on wages of labor and prices of inputs, and this way, raises inflation. A central bank mandated to maintain stable prices while taking account of growth thus .....

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eir problem loans - indeed, the evidence suggests that there might be ever-greening of bad loans, and increased zombie lending, lending to distressed firms at subsidized rates to kick the can of loan defaults down the road, resulting in misallocation of resources, productivity losses and weak growth. This way, attempts to stimulate growth with aggressive policy rate cuts when there are bank balance-sheet problems get wasted and can even backfire in the form of mal-investments, creating false hop .....

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add to the demand impulses. This is the asset price channel of monetary transmission. Higher asset prices can enhance the value of the collateral or net worth of the borrowers, interacting with the bank lending or credit channel, enhancing the capacity to borrow more and at competitive rates, reinforcing the impulses to aggregate demand. Finally, lower domestic interest rates could lead to a depreciation of the domestic currency, on the one hand making exports more competitive in the global mar .....

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time, and may reinforce or interact with each other, so that their individual impact is difficult to disentangle. It also needs to be recognised that the transmission mechanism is complex. The speed and strength at which the central bank s policy rate changes travel to the rest of the economy could vary widely from country to country depending on the structure of the economy and the state of its financial system. Monetary Policy Lags The available empirical evidence for India suggests that monet .....

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course, the expected evolution of output and inflation is uncertain, thereby rendering the transmission analysis even more challenging, adding to the complexity of the central bank s decision-making (and creating exciting opportunities for its critiques!). The key point is that if parts of the transmission machinery are broken, then monetary policy would be less effective. Transmission from Policy Rate to Bank Lending Rates in India: Performance The Indian financial system remains bank-dominated .....

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ss-through from policy rate changes to bank lending rates has been slow and muted. This lack of adequate monetary transmission remains a key policy concern for the Reserve Bank as it blunts the impact of its policy changes on economic activity and inflation. Since the deregulation of interest rates in the early 1990s, the Reserve Bank has made several attempts to improve the speed and extent of the monetary pass-through by refining the process of setting lending interest rates by banks, while at .....

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) MCLR systems. In India, as in a number of other countries, a large proportion of loans is at floating rates, i.e., the interest rate charged to the borrower keeps changing depending on the reset periodicity. The floating rate is linked to some benchmark rate (which ideally varies over time in consonance with the changing macroeconomic and financial conditions and, in particular, the central bank s policy rate). Banks also charge a spread over the benchmark to factor in term premia and credit r .....

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he virtue of an external benchmark is that it is transparent, common across banks, and borrowers can compare various loan offers by simply comparing spreads over the benchmark (all else, such as maturity of the loan, being equal). As market rates normally move in line with the central bank s policy rate, an external benchmark is globally considered and adopted as more appropriate than an internal benchmark for transmitting monetary policy signals. In India, the Reserve Bank has provided the bank .....

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ates (PLR) - the interest rate charged for the most creditworthy borrowers - taking into account factors such as cost of funds and transaction costs. The PLR was, thus, expected to act as a floor for lending above ₹ 2 lakh. However, the experience with its working was not satisfactory mainly for two reasons: (i) both the PLR and the spread charged over the PLR varied widely, and inexplicably so, across banks; and perhaps more importantly, (ii) the PLRs of banks were rigid and inflexible in .....

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t of the lending taking place at interest rates below the announced BPLRs. The share of sub-BPLR lending was as high as 77 per cent in September 2008, rendering it difficult to assess the transmission of policy rate changes of the Reserve Bank to lending rates of banks. The residential housing loans and the consumer durable loans were outside the purview of the BPLR. As such, sub-BPLR lending became a major distortion in terms of cross-subsidisation across borrower categories. Next, the drawback .....

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tion of cost of funds - average, marginal or blended cost - caused opacity in the determination of lending rates by banks and clouded an accurate assessment of the speed and strength of the transmission. Moreover, banks often adjusted the spread over the base rate to benefit the new borrowers while leaving the transmission through the base rate weak for existing borrowers. The weaknesses and rigidities observed with the transmission under the base rate system led to the present system, i.e., the .....

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ad (business strategy and credit risk premium). The base rate system was allowed to be in operation concomitantly for the loans already contracted, pending their maturity or a shift to the MCLR system at mutually agreeable terms between the bank and the borrower. The expected benefits of the MCLR system - better transparency, more flexibility and faster transmission - have, however, continued to elude as documented in the Reserve Bank s recent study - Report of the Internal Study Group to Review .....

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ic over monetary policy cycles - higher during the tightening phase and lower during the easing phase - irrespective of the interest rate system.3 Table 1: Transmission from the Policy Repo Rate to Banks Deposit and Lending Rates (Variation in percentage points) Period Repo Rate Term Deposit Rates Lending Rates Median Term Deposit Rate WADTDR Median Base Rate Median MCLR (1-year) WALR - Outstanding Rupee Loans WALR - Fresh Rupee Loans October 2017 over end-December 2014 -2.00 -1.66 -1.99 -0.75 * .....

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put in place in April 2016. Latest data for WALRs and WADTDR pertain to September 2017. Source: Reserve Bank of India. Transmission from Policy Rate to Bank Lending Rates: Some Issues What explains the slow and incomplete pass-through from the policy rate changes to the lending rates? Two broad factors have dampened transmission to the lending rates. First, a sizeable legacy loan portfolio of banks is still linked to the base rate (about 30 per cent of the outstanding bank loans). Lending rates .....

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thodologies for calculating the base rate and the MCLR to either inflate the base rate and MCLR or prevent the base rate and MCLR from falling in line with the cost of funds.4 Second, spreads charged by banks over MCLR were adjusted to offset the changes in MCLR, thereby impacting the overall reduction in lending rates. The spread over the MCLR could vary from bank to bank due to idiosyncratic factors. However, as the Study Group observed, banks adjusted the spread over the MCLR arbitrarily in s .....

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e benchmark rate or by adjusting the spread? One plausible underlying reason is the rate rigidity on the liability side of banks caused by several factors. In India, about 90 per cent of total liabilities of banks are in the form of deposits. Bank deposits are predominantly at fixed interest rates, thereby imparting rigidity to the transmission process. Further, over 36 per cent of term deposits of banks have maturity of three years and above (Table-2), implying their rates get reset infrequentl .....

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5 years and above 2005 13.9 10.5 15.0 23.4 10.7 18.1 8.4 2010 6.9 8.4 13.7 37.9 12.3 12.4 8.3 2015 7.5 4.1 12.6 40.4 10.1 11.4 13.9 2016 7.2 4.0 9.2 43.3 10.6 11.8 14.0 Source: Handbook of Statistics on the Indian Economy, RBI. What is often not recognised is the large access our banks have to low cost Current and Savings Account (CASA) funds. CASA funds constitute about 40 per cent of aggregate bank deposits with the share of saving deposits at around 31 per cent. Importantly, banks are free t .....

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y 2014, before declining to 6.0 per cent by August 2017. Furthermore, the deterioration in banking sector health due to worsening of asset quality over the past 2-3 years and the expected loan losses in credit portfolios also seem to have induced large variability in spreads in the pricing of assets. With under-capitalized banks aiming to protect their net interest margins6 (NIMs) - indeed, weak banks NIMs have remained broadly unchanged in the face of large stressed assets - so as to maintain p .....

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nterest rates on term deposits in consonance with policy rate signals. Although bank deposits have some distinct advantages in the form of stable returns (vis-à-vis mutual fund schemes) and liquidity (vis-à-vis small saving schemes), bank deposits are in a disadvantageous position in terms of tax-adjusted returns in comparison with these schemes. All of these factors have imparted rigidity to the liability side of banks balance sheet with respect to policy rate changes, in turn ind .....

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n the four major recommendation by the Study Group. In view of the less than desired transmission and transparency under the internal benchmark based lending rate systems - PLR, BPLR, base rate and MCLR - so far, the Study Group has recommended that there is need to shift to an external benchmark based lending rate system. The internal benchmark-based pricing regimes are not in sync with global practices on pricing of bank loans. Given the scope of arbitrariness under the MCLR system, the Study .....

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ernal benchmark. The Study Group has recommended that all floating rate loans extended beginning April 1, 2018 could be referenced to one of the three external benchmarks selected by the Reserve Bank after receiving and evaluating the feedback from stakeholders. Second, the Study Group has recommended that the decision on the spread over the external benchmark could be left to the commercial judgment of banks, with the spread remaining fixed all through the term of the loan, unless there is a cr .....

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to the selected external benchmark. The common theme underlying these recommendations is to improve monetary transmission by ensuring that changes in the policy rate transmit quickly and adequately to banks lending rates in a transparent manner without any cross-subsidisation and discrimination between existing and new borrowers. The idea is also to make banks liability side more flexible so that the objectives of improving monetary transmission by the Reserve Bank and maintaining healthy net in .....

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a calibrated path to the desired benchmarking system. Improving Monetary Transmission: Shoring up Bank Balance Sheets As explained earlier, even as the Reserve Bank has reduced its policy repo rate by 50 bps since October 2016 and by a cumulative 200 bps since December 2014, the banking sector s credit growth has remained much muted. While weak demand for bank credit could be one of the factors leading to the observed slowdown in credit growth, a primary cause of the slowdown had also been the w .....

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f public sector banks (especially the ones with high stressed assets). Against this backdrop, the enactment of the Insolvency and Bankruptcy Code (IBC) in December 2016, the promulgation of the Banking Regulation (Amendment) Ordinance 2017 (since notified as an Act), and the subsequent actions taken thereunder in the form of the Reserve Bank requiring banks refer the largest, material and aged non-performing assets (NPAs) to the IBC, have made the IBC a lynchpin of the new time-bound resolution .....

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xpected to strengthen bank balance sheets significantly and improve banks ability and willingness to lend at rates in consonance with policy rates and result in an improved monetary transmission. Concluding Observations In summary, efficient monetary transmission is a sine qua non for the successful pursuit of its objectives by any central bank. Over the past two decades, it has been the endeavour of the Reserve Bank to strengthen the monetary transmission process, but these efforts have yet not .....

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A key suggestion before us is to whether to shift the loan pricing system from an internal benchmark to an external benchmark. The Reserve Bank will take a considered view in the matter at an appropriate time. In my view, there is a deeper economic issue at hand in the recommendation to move towards an external benchmark. The issue is: who should bear the interest rate risk in the economy - the borrower, or the depositor, or the bank? Who is likely to be better at managing the interest rate risk .....

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set interest rate risk globally. A combination of interest-rate risk transfer mechanisms through market products such as interest-rate derivatives (swaps, in particular) and securitized products such as collateralized loan obligations (CLOs) will spring about, provided banks indeed have to manage the interest rate risk rather than have it as a matter of convenience to pass it onto borrowers. Hopefully, I will focus sometime soon on these issues in a companion piece - Monetary Transmission in Ind .....

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any given point of time could be vastly different from these average lags, depending upon factors such as the stage of the domestic and the global business cycle, the domestic liquidity and financial conditions, the fiscal stance, the health of the domestic banking sector and the non-banking sector. 3For instance, the pass-through to outstanding loans from the repo rate was around 60 per cent during the tightening phase (July 2010 to March 2012), while it was less than 40 per cent during the sub .....

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