As Reserve Bank Governor Raghuram Rajan left interest rates untouched in his monetary policy Tuesday, he did so expressing disappointment that monetary transmission hasn’t yet taken place. What exactly is monetary transmission, Sanjay Vijayakumar explains:
What is monetary transmission?
To put it simply, monetary transmission is the process through which changes in a central bank’s monetary policy gets reflected in the real economy. So, for instance, if a central bank reduces interest rates it charges borrowing banks, it would expect that reduction to be passed on to eventual customers as a result of the monetary transmission process.
Usually, there is a lag between the actions of the central bank and those of the commercial banks. The lag is less when central banks raise interest rates.
Why is monetary transmission being mentioned now?
So far this year, the Reserve Bank of India has cut the interest rates it charges borrowing banks by 50 basis points (from 8 per cent to 7.5 per cent). And yet, commercial banks have largely resisted passing this benefit on to their borrowers. Lower interest rates are important to spur consumption as also investment, and therefore economic growth.
In the first monetary policy meeting of the financial year 2015-16, the RBI signalled that it may not be inclined to further interest rate reductions without appropriate rate actions by banks.
Why are banks unable to cut rates?
Banks can raise lending rates faster after a policy rate hike because loans are mostly at variable rates and can be re-priced faster. However, keeping pace with a policy rate cut is unpalatable for commercial banks. That’s because the cost of deposits can’t be reduced in the short term, they carrying a fixed rate of interest. Also, with competition from small savings instruments, it is difficult to cut rates it offers depositors.
What are the other challenges for banks?
One view is that business is tepid, as credit offtake is low. For instance, the credit growth has slowed to 11 per cent in 2014-15, down from 15 per cent previous year. Banks have also seen a major stress in their balance sheets due to a high level of bad loans. And as a report by brokerage Anand Rathi indicates, public sector banks get little fee-based income, i.e. income that isn’t dependent on interest rates. This makes the monetary transmission process longer.
