RBI kept the policy rates unchanged today. This pause is after five continuous cuts aggregating to 135 basis points. My take on what has been the impact of monetary policy actions so far and what possibly would be needed to revive the credit and growth cycle.

RBI Keeps Policy Rates Unchanged:

Is Monetary Policy Working to Spur Credit and Growth

Monetary Policy Committee (MPC) of Reserve Bank of India today kept the repo rate unchanged at 5.15% and reverse repo rate at 4.90%. This pause keeps the aggregate rate cuts unchanged to 135 basis cuts effected in last five MPC meetings.

The articulated objective of rate cuts effected this year is to boost sagging GDP growth? So far, the rates cuts have not contributed to either rise in credit or GDP growth. GDP growth has actually come down to the decadal low of 4.5% in Q2- FY20. Credit growth has slipped below 10% from high of about 15% last year.

Is the monetary policy pursued so far delivering?

Central Banks have two major instruments to spur growth- lowering interest rates and expanding their balance sheet for creating larger monetary base.

The Central Banks expects to reduce the cost of credit by bringing down the policy rates. Lower repo rates are meant to provide cheaper short-term resources to Banks, which in turn, are expected to reset the entire interest rate structure. Lower interest rates are expected to drive both consumption and investment. Consumers tend to avail more credit for buying houses, cars, other durable assets and also for pure consumption - on travel, education and eating out, if the credit is available at low rates- either close to inflation rate or still better if at less than the inflation rates. Likewise, businessmen tend to take investment calls when they believe that the cost of capital has come down relative to their expected returns from the investment.

Private consumption grew at 10.6% and 12% respectively in 2017-18 and 2018-19 in nominal terms. Private consumption growth was less than 8% in nominal terms in the Q2 of 2019-20. Investment growth, measured by growth in fixed capital formation, has seen sharper decline. Gross fixed capital formation recorded high rates of 13% and 13.7% in nominal terms in last two financial years, whereas it has come down to -.9% in current prices during Q2 of 2019-20. Quite obviously, four cuts effected until September 2019 have not really worked their way to spur growth.

Until some time back, the Bank credit was growing at double digit growth rates (since December 2017), with credit growth crossing even 15% for some months during third quarter of 2018-19. However, credit growth has fallen below 10% during the current financial year. Bank credit was at Rs. 98.48 lakh crore on 8th November 2019, rising by only 7.47% on year on year basis. As deposits have also been growing at much subdued rate (aggregate deposits 129.99 lakh crore on 8^th November 2019; year on year growth 9.02%), net increase in government securities held by the Banks has also been only 8.24%.

Interest rate channel in expanding credit and consequently growth works through reduction in the rates of credit available. A comparative analysis of movement of key lending rates during the current year, however, suggest that there has been hardly any downward movement. Weighted Average Lending Rate (WALR) of all outstanding loans in the Banking system has actually gone up from 10.38% in January 2019 to 10.43% in September 2019; WALR of fresh loans extended though, did come down from 9.97% to 9.58% during this period. Marginal Cost of Lending Rate (MCLR) was sticky around 8.7% to 8.8% during Jan-July 2019; it is showing signs of notable reduction recently as it has come down to 8.35% in October 2019. Surprisingly, the real interest rates for actual borrowers (difference between the fresh loans’ WALR and the policy repo rate) has actually gone up during this period.  While repo rates have come down by over 1% during this period, the new loans lending rate (fresh loans WALR) has got reduced by only 40 basis points. This kind of real increase in interest rates actually paid/payable by the borrowers certainly cannot excite the businessmen to take investment call and to borrow more.

The stickiness in the interest rates faced by consumers and businessmen confirm ineffectiveness of cuts effected in policy rates. Dealing with stickiness in the interest rates for borrowers require much more to be done by the Government and the Banks than the Central Bank alone. Dominance of fiscal deficits and public sector borrowing requirement has continued competition for credit resources tempering possibility of interest rates coming down. The Government has continued with high interest rates on small savings instruments and the Banks have hardly adjusted interest rates on deposits. The Banks have also been hemorrhaging on net income spreads consequent to large presence of non-performing loans forcing the Banks to keep expected Net Interest Income (NIIs) quite high in India. These issues would have to be addressed besides working on policy repo rates to have real prospect of reduction in interest rates paid/payable by borrowers/businessmen.

Second channel for expanding credit and thereby growth is expansion of money supply.

Reserve Bank of India has been expanding its balance sheet at a reasonably good clip during the current year (at over 15.21% year on year at Rs. 42.44 lakh crore on 22^nd November 2019) as well using both the engines- foreign currency assets (FCA) and domestic rupee-securities assets (DRA). The foreign currency assets have expanded from Rs. 26.42 lakh crore (in rupee equivalent) as on November 23, 2018 to Rs. 30.15 lakh crore as on November 22, 2019, an increase of 14.10%. Rupee securities have expanded at a much higher rate of 38% during this period from Rs. 7.24 lakh crore to Rs. 9.99 lakh crore.

To expand the lendable resources and liquidity in the system, the RBI has been carrying out substantial operations in the form of Open Market Operations (OMOs) purchasing government securities. This year as on 22^nd November, on year on year basis, RBI’s net credit (which reflects essentially purchase of government securities in OMOs) has gone up by as much as Rs. 2.57 lakh crore. RBI has also been on the purchasing spree on foreign exchange front as well to inject more liquidity in the system. RBI foreign currency assets on year on year basis as on 22^nd November have expanded by a whopping Rs. 4.10 lakh crore. This is also reflected in growth of foreign currency reserves at $448.60 billion as on November 22, 2019, rising by a massive amount of $55.81 billion on year on year basis.

The expansion of balance sheet should ordinarily lead to expansion in availability of lendable resources to the Banks. However, if the Banks are not inclined to lend or are unable to lend, for whatever reasons, the expansion in balance sheet can get neutralized by the Banks returning liquidity or lendable resources to the Reserve Bank of India through Reverse Repo route. The RBI has been net recipient of lendable resources from the Banks during the current year even though Banks’ returns from reverse repo deposits with the RBI give the lowest returns to them. On year on year basis, the RBI’s net credit to Banks and Commercial sector (essentially to Banks) has declined by 3.07 lakh crore as on November 22, 2019.

This possibly explains the lack of credit expansion.

India will have to look at this phenomenon of the Banks not lending to consumers and businessmen, preferring instead to park their additional lending resources/ liquidity with the RBI, earning practically negative returns mostly.

For the present, it seems, that there is disinterest on both sides- borrowers and lenders- for expanding credit. There is major lack of visible investible opportunity in critical investment heavy sectors like housing and construction, power and roads (though there is good expansion in some infrastructure sector like warehousing and airports, albeit not sufficient enough to neutralize the lack of perceived opportunity in other sectors). Likewise, slow down in demand for consumer durables has made weaker investment in manufacturing as well. The sectors which are growing- like starts up- are not funded by the banking system.

Not exactly ‘animal spirits’ but sound business case for improved profitability in stalled sectors of manufacturing and infrastructure would be needed to be made for reviving the investment cycle funded by credit for higher growth. The crisis in several real sectors- most particularly in housing and construction- also mirrored in the Non-Banking sector, would have to be resolved in addition to the crisis in the banking system (capitalization is only a part of solution but not a complete solution) for the rate cuts by the RBI to actually have the desired impact.